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Taxation on Investment Income Explained

Candace Varner

Ben Hake

The Standard Deduction podcast is hosted by Tax Directors Candace Varner and Ben Hake. This podcast is a thoughtful, informed discussion about ideas, trends and developments in taxes related to personal wealth management.

Our mission is to educate and inspire people to make better financial choices through knowledge, tools and strategies. We believe that education and planning are key components of financial success. Come explore relevant financial topics with our team.

Let Tax Directors Candace Varner and Ben Hake help you avoid surprises on Tax Day! Listen as they discuss the ins and outs of taxation on many common types of investment income (including interest income, capital gains distributions and several types of dividends) as well as the importance — and timing — of K-1s.

Important Legal Disclosure: creativeplanning.com/important-disclosure-information/

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Candace Varner: Hello, and welcome to The Standard Deduction. I’m Candace Varner.

Ben Hake: And I am Ben Hake.

Candace: Today we want to talk about one of the things that we talk about with clients very often, which is the taxation of their investment income. Some of the things are pretty clear, and a lot of them are not clear at all, just like everything with tax. So, Ben, start us off with some easy ones that hopefully people know or have heard of before.

Ben: Okay. The two most common ones that we see, and this is, at least the first one is even if you don’t have a big brokerage account, it’s going to be interest income. You’ve got a bank account. Maybe you hold a bond or something like that, or you have some U.S. treasury bonds that have matured or savings bonds that you received from a while ago. All of those kind of make sense. You know, obviously the bank gave you $10 into your bank account, so that’s interest income, and you pick it up as taxation. The other one that, generally speaking, people don’t push back upon is stock sales. So you bought some Amazon shares back in the nineties and now it’s worth 300 times what it was before when you sell that.

Candace: Wow, good call.

Ben: I know. I was going to say, I need to talk to these people to see what they’re recommending next. But generally speaking, those aren’t surprises to people, because most people are aware when they sell something that there could be a gain. But Candace, I know there’s some trickier ones, or at least where it’s not quite as straightforward.

Candace: Yeah, the next big one is dividends. Now, it’s not overly complicated, but you are an owner in a C corporation, usually publicly traded. So think Apple, IBM, Tesla, something you know, or a variety of other funds. And they pay out dividends to their shareholders. So at some frequent interval, each one gets to pick whenever they want to pay them, but you’ll see deposits into your account, not unlike the interest income you were talking about, but these are actually payments back to you as a shareholder.

Now, the thing about the dividends is that they’re, depending on the size of your account and what you’re invested in, they’re usually a lot more substantial than the interest income you just get on your checking account, so they can kind of add up over the year. And this is one of those things that causes what I would call psychological tax issues, because you don’t feel the income. It’s not like your paycheck, where something’s being deposited into your bank account. Now, you are getting money and probably watching that account increase over the year, but it doesn’t feel the same. And so when you get to the end of the year and you get a statement that says, oh, you have $20,000 of dividends that we need to pay tax on, that can come as a surprise to people if they aren’t aware of what they’re getting.

The other thing about dividends is that it’s not as simple as just saying you got 20 grand deposited in your account over the year so we’re going to pay tax on 20 grand. You are, but we also need to know how many of those dividends are qualified dividends. It’s just a subset of dividends that get a preferential rate. And then also a different subset of those dividends is called 199A, which is fairly new since 2018, and that makes those dividends eligible for an additional deduction of 20%.

So it’s not enough to know just how much cash was deposited into your account for dividends. You really need that tax document that says, this is how much is this kind, this is how much is this kind, because it’ll affect the amount of tax that you pay on them. The other one, which we see a lot right now on 1099s is capital gain distributions. Ben, tell us what those are.

Ben: So the capital gain distributions, Candace kind of hit on it earlier, that generally speaking dividends have a set frequency. So a lot of the times it’s paid every quarter. They announce that you’re getting six cents a share. And that’s how it works. The capital gain distributions are not going to be quite that way, but instead get paid out at the very end of the year. And those are going to be a function of what the underlying, generally speaking, a mutual fund’s performance was.

So if the mutual fund throughout the year sold a lot of their assets at a gain, then at the tail end of the year, they’re going to make a distribution to their shareholders of that gain. The kicker here is that it’s not quite as predictable, so it’s not like every quarter I’m going to go out to Yahoo Finance or whatever website you want and look up what that is. Instead, on those last two weeks of December, they’re going to announce what that payment will be.

And the thing we run into as tax preparers is that they’re not necessarily something where it trends the same every year. It’s not like, hey, every year it’s about six cents a share so that’s what we can expect. And 2021 is a great example of that, where a lot of these funds did exceptionally well. Given the market performance, that makes sense. And so seen some outsized capital gain distributions. And when I say outsized, I mean it’s not uncommon for one to have shown a thousand dollars in 2020 and to show five or $6,000, five to six times what it had in the past.

So that also makes it hard to plan estimates around because you don’t necessarily want to pay throughout the year for that. So that’s another item. And again, a lot of people just reinvest those as they’re received. So it may be a large dollar amount that, again, you don’t feel in your bank account. So sometimes it could be a little painful at tax time to pay tax on something that, well, it feels like you never saw it.

Candace: Those specifically I know are bothering us as CPAs, because we like predictability. We like knowns. We don’t like surprises, and we like our projections to be accurate. So that’s been frustrating.

The last one I want to touch on is if we want to make things a little bit more complicated, everything we’ve talked about so far, or the dividends I was talking about, would be a C corporation, which is fairly straightforward. But you can also invest in a partnership, and this could be a privately held thing. We see a lot of that, where people will just form their own partnerships or invest in a private partnership that’s for investments, but there are also some that are publicly traded, and it’s important to understand what you’re getting into when you invest in those. It’s not as simple as just, I bought it for five dollars and I’m selling it for 10.

Every year, as a partner in that partnership, you are going to get a form called a K-1, and it’s going to say what your share of the income is every year. And it’s not necessarily what they paid you. The way a partnership is taxed is that altogether as the partnership, let’s say there’s $30,000 of dividends and $10,000 of interest. The partnership itself is not going to pay any tax. No matter what happens, that partnership is not paying tax. All of that income is going to get pushed out, or we’ll say passed through, to the partners, based on their ownership. If you own 50% of it, you get half of each one of those numbers, 10%, et cetera, et cetera.

And so if you’re buying something that’s publicly traded, you might only own 0.02%, but you’re still going to get a tax document that says, here’s your share of all of our interest and dividends and charitable contributions and each specific item. So it’s not just one number, it’s maybe 30 different line items that have all different tax treatment. It can really complicate your tax situation. And the big key on this one is, like I said, it doesn’t correlate to when they’re making distributions of cash. So this is not the same as I saw deposits in my account for $5,000 three times last year so I paid tax on $15,000. You might see zero and still owe tax on that $15,000, and we’ll call that phantom income.

So it’s just something really important to be aware of. All of this stuff is just to say, you don’t need to understand how each type of income is taxed or all the fun stuff that Ben and I really enjoy digging into in the tax code. But what you do want to make sure is that you are aware of what’s going to happen before you’re making the decisions on what to invest in because it’s really frustrating to come to tax season and then, surprise, find out you didn’t know you were even waiting for a K-1. Maybe you already filed. You didn’t understand what you were investing in, or you don’t have the cash available to pay tax on that income that was phantom income.

So just to be aware, again, we don’t like surprises. Most clients don’t either. They want to know how much they’re going to owe and when they’re going to owe it. And the thing about a lot of this is just timing. The tax documents come out rather late. Those K-1s can come out even over the summer or in the fall. You might not know by the time you’re even extending your return. So just be careful what you’re investing in and make sure you know what it is up front so that you have no surprises come tax day. That’s it for us. As always, thanks for listening.

Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.

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