Taxation of profits from investment differs from one investment to another; the time period in which the investment has been held; and how the profit was realized. Knowing how profits from investments are taxed allows investors to make realistic plans; to avoid surprises; and to maintain accurate accounting records. Common taxable profits include interest, dividends, and capital gains from the sale of an investment for more than the original purchase price. Additionally, there are many variations to tax laws between countries; therefore, the specific tax rates and tax-free amounts will vary depending on the country’s tax laws. Having a general understanding of how investment profits are taxed will allow you to make more intelligent decisions about your investments.
1. Identify the Major Categories of Taxable Investment Profits
The majority of investment profits fall within one of three categories. In most cases, these categories will have their own set of tax rules; although the profit may come from the same account.
Examples of Common Taxable Profit Types Include:
Interest: Earnings from saving accounts, bonds, or other fixed-income investments.
Dividends: Payments made by corporations to their shareholders.
Capital gains: Profit from selling an investment for greater than the original purchase price.
There are additional ways that investment can produce taxable income through distributions or rental income, depending on the investment vehicle.
2. Understand Capital Gains and Holding Periods
Capital gains arise from the sale of an investment for a profit greater than the original cost basis (the amount paid for the investment including certain fees). Conversely, capital losses arise from the sale of an investment for a price less than the original cost basis.
In addition, most countries provide varying levels of tax relief based on the length of time that an investment has been held. For example, the longer that an investment is held, the more likely it is that a lower tax rate will be applied to any capital gains realized upon the sale of the investment. Similarly, investments held for a shorter period of time are typically subject to ordinary income taxation.
Important Items to Consider When Tracking Investments:
Date of purchase and date of sale.
Original cost basis and fees associated with each transaction.
Net gain or net loss resulting from each transaction after deducting fees.
Classification of the gain as either long-term or short-term according to local tax regulations.
Proper documentation is essential as failure to document the original cost basis of an investment can result in overpayment of taxes.
3. Determine How Dividends and Interest Income Are Generally Taxed
Dividend income is generally subject to tax in the form of ordinary income or in a separate tax category based on the country of origin of the dividend and/or the type of dividend. In addition, many countries impose withholding tax prior to distribution of dividend income to the shareholder.
Interest income is generally subject to ordinary income taxation. As such, interest-bearing investments may be less tax efficient in certain jurisdictions relative to investments in long term-growth investments.
Key Considerations to Evaluate in a Particular Jurisdiction Include:
Whether different classifications of dividends are taxed differently;
Whether withholding tax is imposed and at what rate;
Whether international tax treaties reduce the withholding tax applicable to foreign investments;
How bond interest is taxed relative to bank interest;
These factors can have a significant impact on after-tax returns.
4. Engage in Tax-Savvy Investing Strategies and Avoid Common Pitfalls
While tax savvy investing strategies do not involve illegal evasion of tax obligations, they do involve using lawful means to minimize unnecessary tax burdens and maximize predictability.
Common Tax-Savvy Investing Strategies Include:
Utilizing tax-favored accounts whenever possible.
Retaining investments for extended periods of time in order to take advantage of favorable tax rates on long-term capital gains.
Offsetting gains by realizing losses, as allowed by local tax authorities.
Documenting all purchases, sales, and distributions of investments.
Setting aside funds for tax obligations prior to distributing profits.
One common mistake investors make is failing to recognize that taxes are due immediately upon realization of profit, particularly when an investor realizes multiple transactions throughout the course of the year.
Conclusion
Investors need to understand how their profits from investments are taxed, both by identifying the distinctions between interest, dividends, and capital gains; and by understanding how the holding periods and tax laws in each individual country affect each type of profit. Maintaining accurate records and engaging in basic tax planning can help to prevent surprise tax bills and enhance after-tax returns. As tax laws vary significantly by country and are subject to change, consulting a qualified tax professional in each country where you invest and conducting research on current tax laws in each country is advisable. Employing a disciplined tax strategy is a valuable component of maximizing long-term investing success and maintaining confidence in your financial situation.