Individual (“Personal”) or Joint Taxable Accounts
With taxable investment accounts, you generally owe taxes each year on the dividends and other distributions paid to you that year. You may also owe taxes when you sell shares, depending on whether or not you’ve realized capital gains on the investment.
Taxation of Dividends
Most ETFs pay dividends, reported on Form 1099-DIV. These are generally taxable, typically at your ordinary marginal tax rate (0-39.6%, Federal). For high earners, an additional 3.8% “net investment income tax” applies. Certain ETFs that hold stocks may distribute “qualified” dividends, which are potentially subject to lower tax rates (Box 1b). Some ETFs hold municipal bonds, which pay dividends that are partially or wholly exempt from federal and/or state tax (Box 10 of 1099-DIV).
Some ETFs make distributions parts of which are not taxed as dividends, but rather as capital gains, or return of capital. Capital gains distributed are reported on Form 1099-DIV as well (Box 2a). Return of capital is rare, but could apply, for example, to real estate ETFs that sell some of their holdings, and is reported in Box 3, 8 or 9 (See IRS Pub 17 for details).
Foreign Tax Paid
For ETFs with non-US holdings, the 1099-DIV can indicate foreign tax paid. This could happen when such ETFs have already paid foreign taxes on distributions made by companies in foreign jurisdictions, before passing them on to U.S. shareholders. To mitigate double taxation on the same income, the U.S. rules potentially allow for a deduction or tax credit for these amounts (Box 6).
Taxation of Capital Gains
At Cambria Investments, we sell shares on your behalf whenever you withdraw funds, change your allocation, or we rebalance, harvest losses, or assess our fee. When you sell shares that have appreciated, you realize capital gains tax. If the investment has depreciated in value, you realize a capital loss, which is used to offset other gains that you realized that year, and any excess loss may be deductible from your earned income, up to a threshold set by the IRS. Losses not used that year may be carried forward to future years. The amount of capital gains tax you owe depends on your net gains (including losses carried over from prior years) and how long you held your investments before selling. Short-term capital gains tax applies if you sell shares you held for one year or less. The federal short-term capital gains tax rate is the same rate as your income tax rate (0-39.6%). Long-term capital gains tax applies if you sold shares you held longer than a year, and ranges from 0-20%. For high earners, an additional 3.8% “net investment income tax” is added for both. For each ETF across your portfolio, Cambria’s TaxMin algorithm automatically sells losses first (starting with shares which have the highest cost) and if realizing gains is unavoidable, it prefers long-term over short-term, which is likely to reduce your tax burden. All sales, including sale price, cost basis, and holding period, are reported on Form 1099-B.
Traditional IRA or SEP IRA
Traditional and SEP IRAs may afford a deduction against your ordinary income in the tax year during which you contribute funds, if you qualify based on your income. Any dividends you receive are automatically reinvested by Cambria Investments, and grow tax-free until withdrawal. When you withdraw from the account, taxes are generally due at your ordinary income tax rate applicable at that time, both on earnings and on all contribution amounts that were previously deducted. Penalties may also be due if you don’t meet the withdrawal qualifications (e.g., you withdraw before age 59.5). Read more from the IRS on IRAs and SEP IRAs.
Roth IRA contributions are made with dollars you’ve already been taxed on — you don’t get a deduction. However, at retirement, as long as you’ve held the account for at least five years and met the other qualified withdrawal criteria, none of the amount withdrawn is taxed. Any dividends you receive are automatically reinvested by Cambria Investments, grow tax-free, and are also withdrawn tax-free. Read more from the IRS on Roth IRAs.
Cambria Investments is not a tax advisor, nor should any information in this article be considered tax advice. Please consult a tax professional.