Taxation of Investment vehicles Flashcards
Taxation of Bonds
Returns from most bonds are taxed at regular income rate. Interest income from most bonds issued by states, municipalities, and their agencies need not be included in taxable income in determining the amount of federal taxes that are owed.
Tax equivalent yield
TEY = TaxFreeYield / (1−TaxBracket)
Premium/Discount Consideration
If you pay a premium to buy a bond, the premium is part of your basis in the bond. If the bond yields taxable interest, you can choose to amortize the premium. This generally means that each year, over the life of the bond, you use a part of the premium to reduce the amount of interest included in your income.
U.S. Government Bonds
U.S. government Treasury bills, notes and bonds are subject to federal taxes, such as income, estate, gift, and excise taxes and, where applicable, withholding tax. However, interest earned on Treasury bills, notes and bonds is exempt from state and local income taxes. This is due to a reciprocal agreement between the federal government and state governments.
Types of US Treasuries
T-Bills Less than 1 year
T-Notes 2 to 10 years
T-Bonds 10 to 30 years
Zero Coupon Bonds
Zero coupon bonds are bonds that don’t pay interest. Instead, these bonds are sold at a discount from their face or par value, and at maturity they return their entire par value.
Taxation of zero coupon bond
The tax treatment of zero coupon treasury bonds is different from that of zero coupon municipal bonds. The major disadvantage of these bonds is that while the holder does not receive any income annually, he or she is taxed as though receiving interest. The Internal Revenue Service (IRS) considers any annual appreciation in value, or undistributed interest, as subject to tax. This income is commonly known as phantom income.
Reinvested dividends
Even when dividends are not paid out in cash, they are taxed as ordinary income.
Basis Determination
The starting basis is simply what a person initially pays for the purchase of the stock, plus any cost of purchase such as commissions. If the person received the stock as an inheritance, the starting basis is the value of the stock on the date the original owner died. This is called a stepped-up basis.
If the stock is given as a gift, the starting basis is the lesser of either:
the starting basis for the person who gifted the stock, or
the market value of the stock on the date of the gift.
First In First Out cost basis
Most effective when the first shares bought were the most expensive.
Average Cost
This method is most effective if the shares purchased first have the lowest cost basis.
