Understanding the tax terms and how different investments incur a tax liability can help you strategise your investment plan.
Capital Gains Tax:
Capital gains tax is a tax on the profits of your investment. The profits are calculated as the difference between the amount you bought the asset for and the amount you received when you sold it.
You only pay capital gains taxes when you sell an investment. For example, let’s say you bought an asset for $100 a share, and it grew to $500 a share in a year. You had capital gains of $400. If you keep the investment (don’t sell it), you don’t pay taxes on the $400 per share. But, if you sold your shares for $500 per share, you’d pay capital gains taxes on the $400 per share you earned. In other words, you don’t pay the taxes until you have the cash in hand.
There are both short-term and long-term capital gains. Most short-term capital gains pay the ordinary tax rates and apply to any investments you own for less than one year. Any investments you hold for longer than one year may have lower tax rates, giving you a break on the profits. This includes investments in stocks and physical items such as houses or collectables.
Income is money you earn by working or through investing. Every person must file a tax return each year to determine if you owe taxes or if you overpaid and will get a refund. Governments use income tax revenue for a variety of their services.
Typically, the more money you make, the higher the tax rates you’ll pay. This is to avoid overtaxing the low-income taxpayers while not undertaking the high-income earners.
Tax avoidance sounds bad, but it’s a legal way to lower your tax liability. When a taxpayer uses methods within the law to reduce his/her taxable income, it’s tax avoidance. Typical tax deductions and tax credits are ways to avoid taxes.
Most governments make tax avoidance simple by providing certain deductions and tax credits for situations that help lower a taxpayer’s liabilities. For example, in the United States, taxpayers get a deduction for money they contribute to their retirement account within a specific amount. If they contribute to their retirement, they can deduct the contributions from their taxable income in the year they contribute.
Tax evasion is the opposite of tax avoidance and is illegal. Tax evasion means a taxpayer intentionally altered his/her income to avoid tax liability. This doesn’t include taking standard tax write-offs or deductions. It’s like stealing from the government.
Tax evasion usually results in criminal charges and jail time. There’s a fine line between tax evasion and tax avoidance, but when it’s intentional and a way to defy the government, it’s illegal.
Your liability is the total amount you owe to the local taxing authority. You incur liabilities on any taxable income, including earned income, capital gains, proceeds from the sale of an asset such as a house, and inheritance funds. Most money you receive will have tax liabilities and should always be reported.
A tax liability occurs when you don’t pay your taxes, and a government entity can make a claim on your assets. This may include taking possession of your bank account or placing a lien on a physical investment, such as your home. If they place a lien, when you sell the asset, the proceeds first pay the government before receiving any payment.
A tax shelter is a way of ‘sheltering’ money from tax liability. It is legal as long as you follow the maximum allowed contributions. The most common example is the 401K in the United States. It allows you to set aside a portion of your income in a tax-sheltered account. This lowers your taxable income and, therefore, your tax liability. This is similar to tax minimisation but is NOT tax evasion if it’s done legally.
Tax on Dividends:
If you own dividend stocks, you may get a tax break on the dividends payments. Companies pay dividends on after-tax money. The profits they have after they pay taxes is what they share. You’ll still pay taxes, but at a lower percentage in the United States and some other countries. This doesn’t apply to non-qualified dividends from foreign entities, though – non-qualified dividends are taxed at the regular tax rate.
Tax on Interest Income:
If you hold any assets that earn interest, especially bonds, you’ll pay your regular tax rates on the interest earned. The government considers this ‘ordinary income’, and it doesn’t have any particular tax treatment.
Tax Losses and Wash Sales:
If you have an investment loss, it can offset your tax liability. A common procedure investors use is tax-loss harvesting or wash sales. If they have an asset with significant capital gains that will trigger a large tax liability, they’ll sell other assets that currently have a loss. This means the investment is worth less than their cost basis (the amount they paid).
The loss offsets the gain, which decreases the overall tax liability and is a legal way to lower what you owe.
Main Image: The Guardian Nigeria