Aug 20, 2010

101 on Taxes

Did you ever notice that when you put the words "The" and "IRS" together, it spells "THEIRS?"

Bottom Line: Taxes are always a percentage or a fraction of your profits (also known as Capital Gains). They can never be more than your profits. If you trade short term (less than a year), you can safely choose to ignore the tax implications all together. If you truly want to come out ahead, read on.

Big picture:
The IRS treats income from trading stocks differently than the income you earn while working for some company. You pay Federal tax + State tax + Medicare + Social Security on your taxable income. Income from stocks is subject to just federal and state taxes and there are ways to pay less of that too.

Long Term (stocks held for more than one full year, not calendar year) - Profit made from selling such stocks is currently taxed at flat 15%. This is the BEST way to play the stock market and pay the least tax. Even if you are a billionaire, you still pay 15% in taxes. No other source of income would let you get away by paying just 15%. You can never get rich if you pay too much in taxes! Most CEOs prefer to get compensated in stock as opposed to cash for the exact same reason. They simply have to wait a year and then pay just 15% !!! Nearly all wealthy people use this strategy to pay least possible tax on the income generated from the stock market. There may be liberty and justice for all, but there are tax breaks only for some !!

Short Term (stocks held for less than a full year) - The income generated by selling stocks in a short term is taxed at your current "tax bracket". The term tax bracket is very confusing. None ever falls into one tax bracket. Your income is always split into multiple brackets. Income higher than certain levels get taxed at different rates. Read more about tax brackets . Despite feeling more in control of the market, tax wise this strategy is not the best strategy. You can pay tax as high as 35% and the rate is expected to go up to 43% in 2013. Can you imagine paying more than half of your hard earned stock income to the govt? The average Joe ends up paying upwards of 30% tax on the little profit he made in the stock market, but the Big-Shot millionaire holds his stock for one year and just pays 15%.

Dividends (Short term or long Term): When companies give you cash dividend, its always taxed at flat 15% independent of how long you have held the stock. This is going to expire by end of 2010, but hopefully it gets renewed. To take advantage of the dividend without paying much in taxes, know the ex-date of the dividend payment. This date is usually published about a month or more in advance. If you buy the stock one day before the ex-date you automatically qualify and will receive the dividend. The actual dividend may take a month or more to be physically deposited to your brokerage account. However, keep in mind that on or after the ex-date the price of the stock will automatically adjust (decrease) to reflect the decrease in the perceived value of the company. So a strategy where you buy the stock for the dividend and sell right after doesn't always work. Consider companies like Tiffany or Corning.

REITs - Real Estate Investment Trust - Example: AGNC is a REIT dealing with residential real estate. There are other REITs that deal with Health Care facilities, Office, Hotel/Motel etc. These are special trusts who are forced to give out 90% of their profits to its shareholders in form of dividends. In return, the company doesn't pay any taxes. However, when you get dividend from a REIT, it doesn't get the special 15% preferential treatment any more. In fact, it gets taxed at the same rate as your regular income. The dividend yield from such companies can be sometimes as high as 20%. To take advantage of REITs, its best to buy them in your ROTH IRA account. You never pay taxes again with a ROTH account and so all those jumbo dividends paid can be tax free!

Other Considerations
Whenever your money sits idly with your broker, your broker pays you a little interest. This interest is again taxed by the IRS as your interest income and its the same rate as your regular adjusted gross income tax rate.
Lets say you also borrow on margin from time to time from your broker. You pay some interest to your broker for borrowing the money (usually about 7-8%). Here's the part where you get screwed. This interest is deducted from your adjusted gross income ONLY if its more than 2% of your adjusted gross income. In other words, you earn interest (even $1), its taxable, but if you pay interest to earn any income, its deductible only if it is more than 2% !!!

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