04 11 2013 Investment Overview Taxes are levied on investment income 2 key tax characteristics that affect the after tax returns from investment are o 1 The timing of tax payments or tax benefits o 2 The rate at which investment income or gains are taxed or deductible expenses or losses generate tax savings Income from portfolio investments may be taxed at ordinary rate preferential rates or tax exempt o Portfolio Investments investments producing dividends interest royalties annuities or capital gains o Tax on income from portfolio investments may be imposed annually or may be deferred until the tax payer sells the investment Passive investments generate operating income or operating losses o Operating income is ALWAYS taxed annually at ordinary rates o Operating loses are either deducted annually at ordinary rates or deferred and deducted later at ordinary rates depending on the circumstances Portfolio Income Interest and Dividends Interest income is taxed at ordinary rates while dividend income is generally taxed at lower capital gains rates Interest o Investments generating INTEREST include CDs Savings Accounts Corporate bonds Government bonds o Tax payers recognize interest income from investments WHEN THEY RECEIVE the interest payments o When interest is paid annual at a stated rate of return it is relatively straight forward to modify the rate of return and time value of money formula to account to taxes o Discount Bond bond issued at an amount below the maturity Pg 11 3 value o Premium Bond bond issued at a an amount above the maturity value o Corporate and U S treasury bonds Treasury bonds and treasury notes pay a stated rate of Corporations may pay interested as a stated coupon interest semiannually or they may not Zero Coupon Bonds corporate bonds that do not pay periodic interest Primary differences between treasury and corporate 1 Interest from treasury bonds IS tax exempt from STATE taxation while interest from corporate bonds is not 2 Treasury bonds ALWAYS pay interest periodically while corporate bonds may not Rules for determining timing and interest income from bonds bonds GI Include the actual interest payments received in If a bond was issued at a discount OID rules apply Taxpayers are required to amortize the discount and include the amount of the current year amortization in GI IN ADDITION TO an interest payments that tax payer actually receives If a bond was issued at a premium tax payers may ELECT to amortize the premium The amount of the current year amortization offsets a portion of the actual interest payments that tax payers must include in GI Original tax basis of the bond includes the premium and it is REDUCED by any amortization of bond premium over the life of the bond Tax payer treats some or all od the market discount as interest income when she sells the bond OR the bond matures If the bond is sold prior to maturity the accrued market discount is treated as interest income on the date of sale o Accrued Market Discount an estimated amount of the market discount at the time of purchase based on the number of days the bond is held over the number of days until maturity when the bond is purchased If the bond is held to maturity the ENTIRE bond discount is treated as interest income o US Savings Bonds at maturity U S Savings bonds such as SERIES EE bonds are issued at either face value or at a discount DO NOT pay periodic Interest Interest accumulates over the term of the bonds and is paid when investors redeem them at maturity or earlier The amount of interest income taxpayers recognize WHEN THEY REDEEM the bonds is the excess of the bonds proceeds over the basis bond purchase price Interest may be EXCLUDED from gross income to the extent the bond proceeds are used to pay qualifying educational expenses Dividends o Investments generating dividend income include Direct equity in corporate stocks Investments in mutual funds o Dividend payments are taxed annually o Qualified dividends generally are taxed at a 15 preferential rate Qualified Dividends dividends paid by domestic or certain qualifying corporations provided investors hold the dividend paying stock for MORE THAN 60 days during the 121 day period that begins 60 days before the Ex dividend date Ex Dividend Date the first day on which the purchaser of the stock would not be entitled to receive a declared dividend on the stock Non qualifying dividends are taxed at ordinary rates o Formula for determining the After tax ROR and the After tax Accumulation is identical to the formula used on pg 11 3 Only difference would be the tax rate if they are taxed Portfolio Income Capital Gains and Losses prudentially When tax payers buy and hold assets with appreciation potential they typically are investing in capital assets o Advantages of investing in capital assets Gains are deferred for tax purposes until the tax payer sells or otherwise disposes of the assets Gains are generally taxed at preferential rates relative to ordinary income When a tax payer sells a capital asset for MORE the its tax basis the tax payer recognizes a capital gain Amount realized selling price of a capital asset includes o The cash and FMV of property received MINUS brokers fees and other selling cost o Tax basis initial purchase price other cost incurred to purchase or improve the asset Capital assets such as shares of stock are much more homogenous and harder to track o Tax payers who haven t adequately tracked the basis n their stock are required to use the FIFO method o If good records are maintained you can use the Specific Identification method When selling shares tax payers will choose to sell the shares with the higher basis but when using FIFO you may not have the option to do this o Stock Basis Cost p s of shares acquired on that date You can determine the basis for each block of shares you buy on a certain date 04 11 2013 04 11 2013