Every January mutual fund owners open their mail and find strange forms labeled:
1099-DIV. Accounts for dividends and capital gains distributions that their investments paid them in the previous tax year.
1099-INT. Accounts for interest paid that year.
1099-B. Reports the sales or exchanges of shares that you made that year.
Realized Gains & Losses. Accounts for the long and short-term capital gains that came from any sales or exchanges you made that year.
...and other such things.
This webpages will help you make sense out of all these.
Many mutual funds and ETFs pay quarterly dividends, either in dollars or shares. Such payouts are subject to progressive taxation in that year. By progressive I mean the higher your taxable income is, the more tax you pay on the next dollar earned.
The Federal government's Ordinary Income tax rate is the highest tax rate and the more you make the higher it goes. Many states also have income tax systems.
The Long-Term Capital Gains tax rate is significantly lower than the rate on ordinary income. Some states have lower long-term capital gain tax rates, but some states (like California) taxes long-term gain at the same rate as they tax ordinary income.
So there's some strategy on which kinds whether it's smarter to hold stocks or bonds in taxable investment accounts or in retirement accounts. But before we get to that it helps to understand which mutual funds generate which kinds of distributions.
Interest (reported on the 1099-INT): Taxed as Ordinary Income.
Ordinary Dividends (reported on the 1099-DIV): Taxed as Ordinary Income. In general, bonds pay ordinary dividends.
Qualified Dividends (also reported on the 1099-DIV); taxed at the lower capital gains rate. American stock shares often pay owners with Qualified dividends.
Capital Gains Distributions (also reported on the 1099-DIV). Assuming these arise from the fund manager's selling shares that the fund owned for over one year, they are taxed at the lower capital gains rate.
Capital Gains (reported on the 1099-B). These result from you (the owner) buying, selling or exchanging shares from a fund. When you hold the shares for over one year the gains/losses are taxed at the lower long-term capital gains rate - otherwise, these are short-term capital gains, taxed at the ordinary income rate.
Municipal Bond distributions (including many state bonds) are a taxation special case. These are tax-free at the federal level and in usually also at the state level if you live in that state.
Even if you reinvest all distributions back into the stock or bond fund during the year, you still must pay tax on the fund's distributions from that year. But you only pay tax on the capital gains/losses from your sale or exchange of shares in the year that you sell or exchange them.
By mid-life many people have multiple investment accounts. For example, they have pre-tax money (meaning money that they have not yet paid income tax on) invested in 401K/403B accounts for each employer where they worked. And they may also have pre-tax money invested in traditional IRAs. Investments in these accounts grow tax-free until retirement when they begin selling the shares to generate income to live. Even if they don't need income, when people reach age 70.5 they must, at least, extract what the government calls the Required Minimum Distribution (more on this later). All the money we remove from these accounts is taxed as ordinary income in the year they receive it.
Perhaps they also invested some after-tax money in a Roth IRA. In this case, they paid the tax before investing it, and from there it grows tax-free. And - some great news - they don't have to pay a penny of tax on it when we start withdrawing it in retirement. Neither is it subject to the RMD!
Hopefully, over the years, we also built a sizable taxable investment account.
For people who are several years away from retirement, here's the conventional wisdom for which investments to put in which accounts:
Put funds that generate the most taxable distributions in traditional retirement accounts (401k, 403b, traditional IRAs). These grow tax-free until retirement when, presumably, we will be in a lower tax bracket. In general, this means bonds are a good thing to put in tax-free retirement accounts. Then...
Put the funds that generate the next most taxable distributions in a Roth account.
Put the remainder in taxable investment accounts. In general, this means that stocks are a good thing to put in taxable accounts. Even the stocks you hold which pay dividends, mostly pay these as qualified dividends which are taxed like stocks.
For more on this (and a great graphic) check out The Key to Tax-Efficient Investing (Forbes, written by Laura F. Dogu and others).
Here's a concept that is easy to miss. It is a tax-smart strategy for generating a stream of money from a taxable account. While this is useful for anyone, it is especially useful for retirees who need to supplement Social Security beyond what they can do using tax-free retirement accounts.
During the accumulation years, most of us routinely reinvest all dividends and capital gain distributions back into the investment that generated them. This is smart and results in a fast-growing portfolio. In taxable accounts, this results in annual taxes as triggered by the 1099's we receive each January. So far, so good.
Then in retirement, many of us hit a point where we need to start extracting money from our taxable accounts. So we periodically sell shares - while continuing to reinvest distributions! This means we now have two taxable things going on, the taxation on the reinvested distributions AND the capital gains tax due to the shares we sell to generate living money!
There is a better way: stop reinvesting distributions and start diverting this stream of money into a money market fund or your checking account - and live on this money. You pay taxes on this distribution stream every year, whether you reinvest it or spend it. So spend from the distribution stream before selling shares.
See Retirement Funding for more.
If we leave a taxable account to our heirs, the cost basis is stepped up to the value of the assets at the time of death. This is just like in the case of leaving our house to our heirs (see Home Sale Math). So our heirs pay tax only on gains starting from when we died.
But if we leave a tax-deferred account to our heirs, they will be subject to some Required Minimum Distribution rules and will pay tax at their top brackets when they sell shares. For more on this, check out Retirement Funding.
All the best, Tim