Taxation of Investment Vehicles

Dividend Taxation

Dividends represent a share of a company's profits paid to shareholders. The tax treatment depends on whether dividends are classified as qualified or ordinary (non-qualified).

Qualified Dividends

Qualified dividends receive preferential tax treatment, being taxed at the same rates as long-term capital gains (0%, 15%, or 20%).

Requirements for Qualified Dividend Treatment:

1. Paid by a U.S. corporation or qualified foreign corporation (includes most major foreign companies on U.S. exchanges)
2. Not specifically excluded by the IRS (certain dividends don't qualify)
3. Holding period requirement met: Must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date

CFP Exam Tip: The 60/121-day rule is frequently tested. Count 60 days before the ex-dividend date--the investor must have held shares for more than 60 days within that 121-day window.

Non-Qualified (Ordinary) Dividends

Non-qualified dividends are taxed as ordinary income at the taxpayer's marginal tax rate (10%-37% for 2025/2026).

Examples of Non-Qualified Dividends:

• Dividends from money market accounts
• REIT dividends (generally)
• Dividends on shares held less than the required holding period
• Dividends paid on employee stock options
• Credit union dividends

Stock Dividends

Stock dividends (receiving additional shares rather than cash) are generally not taxable to the shareholder at the time received. However, the cost basis of all shares is adjusted, and taxes are due when shares are eventually sold.

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Capital Gains Taxation

Capital gains result from selling an investment for more than its cost basis. The tax rate depends on the holding period.

Short-Term vs. Long-Term Capital Gains

CFP Exam Tip: "More than one year" means at least one year AND one day. An asset purchased January 1, 2025 must be sold on or after January 2, 2026 to qualify for long-term treatment.

2025 Long-Term Capital Gains Tax Rates

2026 Long-Term Capital Gains Tax Rates

Short-Term Capital Gains Tax Rates (2025/2026)

Short-term capital gains are taxed as ordinary income. The current rates are:

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Net Investment Income Tax (NIIT)

The Net Investment Income Tax (NIIT) is an additional 3.8% tax on investment income for high-income taxpayers, enacted as part of the Affordable Care Act.

NIIT Thresholds (Not Indexed for Inflation)

Important: These individual thresholds have NOT been adjusted for inflation since 2013, meaning more taxpayers become subject to NIIT each year as incomes rise.

How NIIT Is Calculated

NIIT equals 3.8% of the lesser of:

• Net investment income, OR
• The amount by which MAGI exceeds the threshold

Example: A single filer has $250,000 MAGI and $60,000 of net investment income.

• Amount over threshold: $250,000 - $200,000 = $50,000
• NIIT = 3.8% x $50,000 = $1,900

What Counts as Net Investment Income?

Included:

• Interest, dividends, capital gains
• Rental and royalty income
• Passive business income
• Annuity income

Excluded:

• Wages and self-employment income
• Tax-exempt municipal bond interest
• Distributions from retirement accounts (IRAs, 401(k)s)
• Social Security benefits

Maximum Effective Tax Rates on Investment Income

For high-income taxpayers subject to both the 20% long-term capital gains rate AND the 3.8% NIIT:

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The Wash Sale Rule

The wash sale rule prevents taxpayers from claiming a tax deduction for a loss on a security they essentially still own.

The 30-Day Rule

Under IRS rules, a wash sale occurs when you sell a security at a loss and purchase a substantially identical security within:

• 30 days before the sale, OR
• 30 days after the sale

This creates a total 61-day window (30 days before + sale date + 30 days after) where repurchasing triggers the wash sale rule.

What Happens in a Wash Sale?

When a wash sale occurs:

1. The loss is disallowed for current tax purposes
2. The disallowed loss is added to the cost basis of the replacement shares
3. The holding period of the original shares carries over to the replacement shares

Example:

• Buy 100 shares of XYZ for $5,000 (cost basis $50/share)
• Sell 100 shares for $3,500 (loss of $1,500)
• Repurchase 100 shares within 30 days for $3,800

Result:

• The $1,500 loss is disallowed
• New cost basis = $3,800 + $1,500 = $5,300 ($53/share)
• When eventually sold, the higher basis reduces future gain

Key Wash Sale Rule Points

1. Applies across all accounts: The rule applies to trades in your brokerage account, IRA, and even your spouse's accounts
2. Substantially identical: Includes the same stock, options on that stock, and possibly very similar securities (e.g., different share classes of the same mutual fund)
3. Not defined precisely: The IRS determines "substantially identical" on a case-by-case basis
4. Safe harbor: Wait at least 31 days after the sale to repurchase

CFP Exam Tip: The wash sale rule does NOT prevent you from eventually claiming the loss--it simply defers it by adding the disallowed loss to the new shares' basis.

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Tax-Loss Harvesting

Tax-loss harvesting is the strategy of selling investments at a loss to offset capital gains and potentially reduce taxable income.

How Tax-Loss Harvesting Works

1. Identify losing positions in taxable accounts
2. Sell the losing investment to realize the capital loss
3. Reinvest in a similar (but not substantially identical) security to maintain market exposure
4. Use losses to offset gains

Loss Offset Rules

Capital losses offset capital gains in this order:

1. First: Short-term losses offset short-term gains
2. Second: Long-term losses offset long-term gains
3. Then: Net losses of one type offset net gains of the other type

If net capital losses exceed capital gains, up to $3,000 ($1,500 if married filing separately) can be deducted against ordinary income per year. Excess losses carry forward indefinitely.

Tax-Loss Harvesting Strategies

Avoiding Wash Sales While Harvesting

To avoid wash sales while maintaining market exposure:

• Switch to similar but not identical security (e.g., sell S&P 500 ETF, buy Total Market ETF)
• Wait 31 days before repurchasing identical security
• Use different fund families (e.g., sell Vanguard fund, buy Fidelity fund tracking same index)

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Cost Basis Methods

Cost basis is the original value of an investment for tax purposes, used to calculate capital gains or losses when sold.

IRS-Approved Cost Basis Methods

FIFO (First In, First Out)

FIFO is the IRS default method if no other method is elected. The first shares purchased are considered the first shares sold.

Example:

• Buy 100 shares at $40
• Buy 100 shares at $50
• Sell 100 shares at $60

Using FIFO: Shares sold are the $40 shares, resulting in $2,000 gain ($6,000 - $4,000)

Implications: In a rising market, FIFO typically results in higher taxes because older (lower cost) shares are sold first.

Specific Identification

Specific identification allows you to designate exactly which shares to sell, providing maximum tax flexibility.

Requirements:

• Must specify shares at time of sale (not retroactively)
• Must receive confirmation from broker
• Keep adequate records identifying each lot

Example: Using the same purchases above, you could specify selling the $50 shares, resulting in only $1,000 gain ($6,000 - $5,000).

Average Cost Method

The average cost method calculates basis by dividing total cost by total shares. This method is only available for mutual funds and dividend reinvestment plan (DRIP) shares.

Example:

• Buy 100 shares at $40 = $4,000
• Buy 100 shares at $50 = $5,000
• Total: 200 shares, $9,000 cost
• Average cost = $45 per share

Key Rules:

• Once you use average cost for a fund, prior shares retain that basis even if you switch methods
• Election must be made in writing (online election counts)
• Not available for individual stocks

Choosing the Right Method