# Basics of Investing & Portfolio Management

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# Investing Tax Basics

### Lesson 9

In this section, we will find out how taxes can affect our investments.
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# Investment Tax Basics

When you start investing, you buy and sell assets, you generate income and you may also get some capital gains. This is great for your long term growth and goal achievement, however, it doesn’t come for free. You may have to pay taxes on your investment income as well as on your realized capital gains.

The topic of investment taxes can be a bit scary sometimes, but if you follow a few simple rules, you will be able to tackle your investment taxes with no problem.

First of all, we will explain the two main ways you pay taxes when investing:

## Taxes on Investment Income

Investment income is generated by owning stock of companies that distribute after-tax earnings to the shareholders in the form of dividends (as we have seen before), but it also can be generated by owning bonds that yield a certain interest.

Most dividends that you may receive from US companies have already been taxed because companies distribute their earnings (pay dividends) after they have paid taxes on them. Therefore, this dividend income is only taxed at a maximum of 20% (only applies to qualified dividends). Non-qualifying dividends or dividends from some foreign countries may be taxed at the full income tax rate.

Also, if you hold an asset that pays dividends or interest for more than a year, that income will be taxed at a lower rate (you will pay less in taxes). If you hold an asset for the short-term, you will have to pay the full income tax rate.

Example:

You own 1 share of Microsoft, which pays you \$5 in total dividends every quarter (3 months). If you own the stock for over one year, you will have to pay out say 20% on dividend income tax. If you own it for less, imagine you sell it within 3 months, you will have to pay the regular tax rate, assume it to be 40%.

#### Long-term dividend

• \$5 per quarter x 4 quarters (1 year)  = \$20 of yearly dividend income
• \$20 yearly dividend x 20% tax rate = \$4 income tax (to pay)
• \$20 yearly dividend – \$4 income tax = \$16 net dividend income (to keep or reinvest)

#### Short-term dividend

• \$5 per quarter x 1 quarters (3 months)  = \$5 of total dividend income
• \$5 total dividend x 40% tax rate = \$2 income tax (to pay)
• \$5 total dividend – \$2 income tax = \$3 net dividend income (to keep or reinvest)

Over time, taxes can affect your interest earnings significantly.

## Taxes on Capital Gains

As we have seen in past sections, when you own securities and you sell them for more than what you paid for them, the positive difference is called capital gains.

If you bought 1 Microsoft share for \$180 and sold it 1 year later for \$200, you generated \$20 in capital gains (\$200 – \$180)

You will most likely have to pay taxes on these gains at the end of every year.

If you held the security for longer than a year, it would be considered a long-term capital gain, and it will be taxed at a lower rate. If you kept it for less, it would be considered a short-term capital gain, which is taxed at the regular tax rate. This works in a similar way as with dividend income.

Example:

#### Long-term capital gains

• \$200 sale price – \$180 purchase price = \$20 capital gains
• \$20 capital gains x 20% tax rate = \$4 investment tax (to pay)
• \$20 capital gain – \$4 tax = \$16 net capital gain (to keep or reinvest)

The tax rate can be 0%, 15% or 20%, depending on a few factors.

#### Short-term capital gains

• \$200 sale price – \$180 purchase price = \$20 capital gains
• \$20 capital gains x 40% tax rate = \$8 investment tax (to pay)
• \$20 capital gain – \$8 tax = \$12 net capital gain (to keep or reinvest)

The tax rate is typically significantly higher than for long-term capital gains (ranging from 10% to ~40%). Although this may vary depending on the country and the investor.

## Tips to minimize your investment taxes

1. Have a long-term holding strategy: as we have seen, short-term gains are taxed at a higher rate, so you automatically gain an extra few percentage points by holding on to your stock for the long-run.
2. Realize capital losses to offset investment taxes: you may actually benefit from selling some securities that are doing bad! If you have assets that are losing money, you may want to sell them before the year ends (realize capital losses), which will lower the taxes on the overall capital gains. Also, if you have lost a lot of money in one year, you can carry a part of the loss over to the next year.

## Tips to manage your investment taxes

1. Keep track of the money you invest: note the dates you invested money, the security you purchased, and the number of shares. Also, note when you sold the security and for how much.
2. Record any dividends/interest you receive: note the date, the amount per share and the total received.
3. Use a great tax preparation software when doing your taxes: many tax management companies offer amazing, comprehensive services for you to capture everything easily.
4. Use the tax forms your broker prepares for you: many brokers provide investors with extensive documentation and necessary tax forms to present to your tax-preparation company.

Someone that generated a 15% investment return last year but did not take into account the tax effect on the actual gains could perfectly have realized an after-tax return lower than someone who just got a 12% annual return.

In the next section, we will go over some of the main mistakes to avoid when investing.

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