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Question: I know the goal of investing is to buy low and sell high and certainly attempt to accomplish this. One thing that has surprised me in recent years is that I’ve been the recipient of unintended capital gains distributions and taxes that I was not expecting. Can you elaborate on this and help me better understand how this works?
Answer: It’s easy to be confused and not know the difference between capital gains and capital gain distributions. If you sell an investment for more than it cost, after adjustments are made for dividends and distributions, that’s a capital gain. Capital distributions are profits passed on to shareholders from sales made throughout the year by mutual fund managers who are required to pass those profits on to shareholders.
Gains produced by capital distributions can occur without any action on your part. Even if a fund is down or in the red, you could receive a capital gain distribution. This is probably what you experienced in the past. If not explained properly, this can be an unexpected and unpleasant experience. This happens when a fund manager sells particular shares at a profit although the fund experienced a loss.
Mutual funds and exchange traded funds are professionally managed portfolios that collectively hold assets, typically stocks, bonds, cash and other securities.
This allows investors access to a diversified portfolio with various investment objectives. Investors in funds are referred to as shareholders and proportionately participate in the gains and losses of the fund.
Your question is most likely about a non-retirement or taxable account. In these situations, the rate of taxation depends on how long you’ve owned the investment and overall income levels. Short-term holdings are those investments held less than one year and are taxed as ordinary income rates. Long-term gains or those resulting from sales after one year of ownership are generally taxed at lower rates.
Capital gains distributions in qualified retirement accounts like an IRA, 401(k) or 403(b) planning are handled a bit differently. These distributions aren’t taxable until received as a specific distribution from the tax-deferred retirement account.
Dividends, on the other hand, are an incentive or reward for owning shares of a company. Dividends may also be a nice supplement to other income sources. Taxes must be paid on dividend income and depend on the type of dividend received and your income level. The two types of dividends are ordinary and qualified. Ordinary dividends are taxed according to regular income tax rates. Qualified dividends are typically subject to the lower, capital gains rates if they meet special requirements outlined by the IRS. Tax Form 1099-DIV is provided by financial institutions recapping all dividends and capital gains or losses for the previous year.
Understanding the tax treatment of capital gains, losses and dividend income is useful when planning. As you’ve experienced, not all surprises are good. Finding out that you’re paying taxes on something you weren’t aware of is an example of one of those unpleasant surprises. As we approach year-end, this is an appropriate time to review capital gains and losses along with dividend income as you evaluate your financial plan with your trusted team of advisors. In asking questions about these types of issues, your knowledge base is expanded allowing you to better know what you own and why you own it. Stay focused and invest accordingly.
Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. This information is general in nature, it is not a complete statement of all information necessary for making an investment decision. Opinions expressed herein are those of the author as of November 20, 2019 and subject to change at any time. You are encouraged to consult your attorney, accountant or tax advisor with respect to questions taxation and income.
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This article provided by Darcie Guerin, CFP®, First Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email firstname.lastname@example.org Website: www.raymondjames.com/InvestmentInsights.