Tips From Donna Gordon (August 2016 Wesban Monthly)
by Donna Gordon on August 3rd, 2016

​How Your Investment Income Is Taxed

This article provides a quick rundown of how the income produced by different investment types is treated at tax time. While this is by no means an exhaustive list, it covers some of the main categories of income-producing investments and how the income they produce is generally treated by the IRS at tax time. Please note, though, that because every investor's tax situation is unique, you should consult your accountant for verification of your tax status and tax treatment of any investment product mentioned below.
Also, we won't go into capital gains taxes in this article because the tax treatment of them is largely the same regardless of asset class.
Stocks With Qualified Dividends
For most stocks that pay qualified dividends, the tax treatment is pretty straightforward: Investors would report the income on a 1099-DIV in the Qualified Dividends box. Investors in the 10% and 15% brackets will have a zero tax rate on dividends. For individuals in income tax brackets greater than 15% but less than 39.6%, qualified dividends are taxed at 15%. Individuals in the 39.6% tax bracket are subject to a 20% tax on dividends. Higher-income taxpayers are also subject to a 3.8% Medicare surtax on investment income.
In order to be a 'qualified dividend,' the dividend must be issued by a U.S. corporation or a foreign company that either trades on a U.S. exchange, such as an ADR, or is eligible for benefits under a U.S. tax treaty.
Note that in order for the dividend to be 'qualified,' you must have owned the investment for at least 60 days of the 121-day period that begins 60 days before the ex-dividend date, or the day the stock trades without the dividend priced in.
Foreign Stocks With Nonqualified Dividends 
If you're considering a foreign stock for a taxable account, do your homework on whether the company's dividends are qualified. You can find out more about this by consulting IRS Publication 17.
Preferred Stock 
In many (but not all) cases, preferred-stock dividends are treated as qualified dividend income for tax purposes, even though they have many bondlike characteristics such as a stated par value and fixed coupon.
Some dividends paid by U.S. companies are not eligible for lower tax rates, however. Here are a few examples:
Real estate investment trusts do not pay income taxes at the corporate level, but they are required to pay annually at least 90% of their taxable income in the form of shareholder dividends, which is one reason they pay out such large dividends.
Different types of REIT payments are taxed at different rates. In the majority of cases, REIT dividends are considered nonqualified and taxed at ordinary income rates; therefore, they are probably best held in a tax-advantaged account. But there are other types of income payments, such as those distributed from taxable REIT subsidiaries or out of long-term capital gains, which could be subject to lower tax rates; investors should consult with their tax advisors in these cases.
Master limited partnerships are partnerships that trade on a public exchange. They may offer certain tax benefits but also some tax complexity. Unlike with REITs, however, it's best to hold MLPs in a taxable account, because owning them in a tax-deferred account can result in something called unrelated business taxable income, which then requires the account to pay taxes.
MLPs pass through their taxable income to unitholders, who then pay taxes on that income at their own marginal tax rates, often only when the units are sold. These can be a little complicated at tax time, owing to the fact that you don't use a 1099 form to report the distributions but instead have to use a K-1.
Another interesting feature of MLPs is that cash distributions are not directly taxable: The IRS looks at them as returns of capital, so it reduces the investor's cost basis in the MLP. In practical terms, that means that the investor will have to pay taxes on the spread between a lower cost basis and the MLP's price at the time of the sale, but most of the income the MLP distributes from year to year is effectively tax-deferred.
Exchange-traded products can sometimes sidestep tax-reporting complexities, but oftentimes at the expense of the tax benefits one would get if the MLPs were held directly.
Taxable Bonds 
Bond income is generally taxed at investors' ordinary income tax rates in the year it was received. The income is taxable at the federal level in all cases, but Treasury bonds are not subject to state and local income taxes.
As with Treasury bonds, interest payments from Treasury Inflation-Protected Securities, and increases in the principal of TIPS, are subject to federal tax but exempt from state and local income taxes. One additional thing to remember about TIPS, however, is that the amount by which the principal of your TIPS increased because of inflation is taxable for the year in which it occurs, even if your TIPS hasn't matured (in other words, before you would receive an actual payment of principal).
Municipal Bonds 
Muni bonds are issued by state and local governments to finance public projects. In the vast majority of cases, the income paid out by these bonds is not taxed at the federal level. In some instances (particularly if the bond is issued by a state or municipality in which you reside), muni income is not taxed at the state or local level, either. It's also worth noting that income from private-active munis is subject to the Alternative Minimum Tax.
There are typically no dividend or interest payments paid to investors who get exposure to commodities through exchange-traded note (which is an unsecured debt obligation) or grantor trust (which often holds physical commodities) structures. However, if you bought a commodity-futures-based ETN, you might have to report income using a Schedule K-1.
This is for informational purposes only and should not be considered tax or financial planning advice.
Stocks are not guaranteed and have been more volatile than the other asset classes.
Holders of preferred stock are usually guaranteed a dividend payment and their dividends are always paid out before dividends on common stock. In event that the company fails, there's a priority list for a company's obligations, and obligations to preferred stockholders must be met before those to common stockholders. On the other hand, preferred stockholders are lower on the list of investors to be reimbursed than bondholders are.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. Bonds in a portfolio are typically intended to provide income and/or diversification. U.S. government bonds may be exempt from state taxes, and income is taxed as ordinary income in the year received. With government bonds, the investor is a creditor of the government.
A municipal bond investor is a creditor of the issuing municipality, and the bond is subject to default risk. Only insured municipal bonds are guaranteed as to the timely payment of principal and interest by issuer. However, insurance does not eliminate market risk. Municipal bonds may be subject to the Alternative Minimum Tax and state and local taxes, and federal taxes would apply to any capital gains distributions.
Returns and principal invested in REITs are not guaranteed. REITs typically provide high dividends plus the potential for moderate, long-term capital appreciation. A REIT must distribute at least 90% of its taxable income to shareholders annually. Real estate investment options are subject to certain risks, such as risks associated with general and local economic conditions, interest rate fluctuation, credit risks, liquidity risks and corporate structure. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
Transactions in commodities carry a high degree of risk and a substantial potential for loss. In light of the risks, you should undertake commodities transactions only if you understand the nature of the contracts (and contractual relationships) into which you are entering and the extent of your exposure to risk. Trading in commodities is not suitable for many members of the public. You should carefully consider whether this type of trading is appropriate for you in light of your experience, objectives, financial resources, and other relevant circumstances.

A Risk Drill for Your Portfolio

As of early May 2016, the yield on a three-month Treasury bill—often called 'the risk-free rate'—is about 0.22%. Assuming rates remain that low, $10,000 saved today will be worth ... wait for it ... $10,681 in 30 years.
Risk is a fact of life for investors. Yes, it can punish--sometimes severely. And it can surprise, when misunderstood. But risk also can reward, sometimes generously, if managed well, with patience and perspective. The point with risk is not to avoid it--because you can't. But you don't have to blindly submit to it, either. The point with risk is to take it. Actively take it. Deliberately take it. Take it with purpose, in the right balance and for the right reasons.
That can mean owning plenty of equities—even later in your investment years—and embracing securities that entail plenty of volatility on a stand-alone basis. What matters most is your total portfolio's risk level. Do the constituent holdings counterbalance one another, performing well (or poorly) in different market environments? Is the portfolio sufficiently diversified so problems in one security or sector don't bring down the whole ship? And finally, is the total portfolio well-positioned to confront the mother of all risks, falling short?
As you assess whether your portfolio's risk level is appropriate given your goals and life stage, here are some of the key questions, as well as details on how to find the answers. 
Question 1: Is there a risk of falling short?
This is the worst of all risks: not having enough money to fund your goal (retirement, for most people), or perhaps even worse, retiring and then running out of money. Because the risk of falling short carries such enormous repercussions, the centerpiece of any portfolio checkup should be a 'wellness check'—an assessment of whether you're on track to reach your goals given your current investment mix, your current and future savings, and your time horizon. A basic savings calculator like Morningstar's can help you see if you're in the right ballpark; just be sure to use a realistic rate of return (most experts recommend 4% for a balanced portfolio). If it turns out you have a looming shortfall, a combination of portfolio shifts and lifestyle decisions (such as being willing to retire a few years later) can help you bridge the gap. And the earlier you realize you may fall short, the more flexibility you'll have to make a save.
Question 2: Is the asset mix appropriate given life stage?
Is your asset allocation too risky? Because stocks will tend to return more than other asset classes over long periods of time, investors might naturally assume that loading up on them is the way to go. And it's true that younger investors with steady incomes should generally employ the highest equity weightings they can tolerate; over long periods of time, they'll tend to be rewarded for being willing to put up with day-to-day and year-to-year fluctuations, and those fluctuations shouldn't bother them too much given that they don't have an imminent need for their money. 
But there are two key reasons a portfolio's asset allocation can be too risky. The first is if the portfolio is so volatile that the investor could be inclined to retreat to a more defensive position at an inopportune time. The second is if the portfolio's asset mix exposes it to violent swings in value (especially downward) when the investor is getting close to needing the money. Circumventing that risk is the key reason that most retirement portfolio 'glide paths' begin to skew more bond- and cash-heavy for people in their 50s, 60s, and beyond.
Question 3: Will inflation take a big bite out of returns?
This risk factor goes hand-in-hand with the portfolio's asset allocation. Inflation isn't generally a big deal for portfolios with high equity weightings; over long periods of time, stocks will usually deliver a return that's comfortably above inflation, and when inflation is on the move, stocks are often trending up, too. But inflation risk looms large for portfolios with sizable allocations to bonds. Because bonds' income is what it is, regardless of inflation, it will buy less and less if the costs of goods and services trend up. Thus, bond-heavy investors should work hard to ensure that their portfolios include ample exposure to investments with the ability to keep up with, if not out-earn inflation, including stocks and Treasury Inflation-Protected Securities, which have a built-in hedge against inflation.
Question 4: Is the portfolio riding on a single outcome?
Stocks? Check. Bonds? Check. All-weather portfolio? Not so fast. Even portfolios that are dispersed across these two major asset classes may not be all that well-balanced. That's because lower-quality bond types respond to the same forces that stocks do—specifically, the overall health of the economy. That's fine as long as gross domestic product growth is increasing and unemployment is on the decline. But when investors are feeling skittish about the economy, they tend to dump credit-sensitive bond types right along with their stocks. During the financial crisis, for example, categories like high-yield, bank-loan, and emerging-markets bonds all tumbled because investors worried about the creditworthiness of their issuers in a weakening economy. These bonds' losses weren't as high as equities, but nor did they provide any ballast for investors' depressed equity holdings. Thus, another check on your portfolio's overall risk level is the complexion of your fixed-income holdings. Even though credit-sensitive bonds typically provide better yields, high-quality bonds are the better way to diversify stock-heavy portfolios.
Question 5: Is the portfolio overly concentrated?
Packing too much into an individual holding won't be a big risk for most for most mutual fund or exchange-traded fund investors, assuming they don't go overboard with a single concentrated fund or two. Rather, it's more of a risk factor for investors who own at least some individual securities. Newer investors often start out with just a small handful of stocks; sometimes they get lucky, but oftentimes they learn the hard way about the dangers of underdiversification. Concentration risk can be particularly problematic for holders of company stock.
Question 6: Are you a risk factor?
Last but not least, one of the biggest risk factors for many portfolios doesn't lurk inside. Rather, it's the chance that despite your well-laid plans, you'll undermine your results by falling into the fear-greed cycle, or one of the many other behavioral traps that investors face. Such mistimed buying and selling can exact an even bigger toll than investment fees over time. We're all wired differently as investors, so unfortunately there's no one-size-fits-all way to short-circuit behavioral risk factors. However, a few simple steps can help. First, don’t peek at your portfolio or its value; assuming the plan you started with was reasonable, a policy of benign neglect will tend to beat one that's overly busy. Second, consider an all-in-one investment type that allows you to be truly hands-off. While it's still early days for target-date funds, Morningstar's investor return data paint a promising picture of investors' propensity to use such funds well—that is, they tend not to jump in and out of them so they're able to take home a good share of their returns. Last but not least, put as much of your plan on autopilot as possible, automating your ongoing IRA and taxable account contributions, just as is the case with the money going into your 401(k) plan. Not only does such a program instill discipline in your saving and investment habits, but it creates barriers that you'll need to jump over if you decide you want to stop investing when the market gets rough.
This is for informational purposes only and should not be considered financial planning advice.
Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long term does not ensure a profitable outcome, and investing in securities always involves risk of loss.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks are not guaranteed and have been more volatile than the other asset classes.
401(k) and IRA plans are long-term retirement-savings vehicles. Funds grow tax-deferred. Withdrawal of pretax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty. Direct contributions to a Roth IRA are not tax-deductible but may be withdrawn free of tax at any time. Earnings may be withdrawn tax and penalty free after a 5 year holding period if the age of 59 1/2 (or other qualifying condition) is met. Otherwise, a 10% federal tax penalty may apply. Please consult with a financial or tax professional for advice specific to your situation.

Don’t Get Caught by These 10 Behavioral Pitfalls

Successful investing is hard, but it doesn't require genius. As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one's own psychological weaknesses.
Over the past several decades, psychology has permeated our culture in many ways. In more recent times, its influences have taken hold in the field of behavioral finance, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.
Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market. In this article, we focus on how the insights from the field of behavioral finance can benefit individual investors. Primarily, we're interested in how we can learn to spot and correct investing mistakes in order to yield greater profits. Following are 10 of the biggest psychological pitfalls.
1. Overconfidence 
Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are. It's what leads 82% of people to say that they are in the top 30% of safe drivers, for example. Moreover, when people say that they're 90% sure of something, studies show that they're right only about 70% of the time. Such optimism isn't always bad. Certainly we'd have a difficult time dealing with life's many setbacks if we were diehard pessimists.
However, overconfidence hurts us as investors when we believe that we're better able to spot the next miracle stock than another investor is. Odds are, we're not. (Nothing personal.) Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly costs plenty and rarely rewards the effort. Trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.
One of the things that drives rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.
2. Selective Memory
Another danger that overconfident behavior might lead to is selective memory. Few of us want to remember a painful event or experience in the past, particularly one that was of our own doing. In terms of investments, we certainly don't want to remember those stock calls that we missed much less those that proved to be mistakes that ended in losses.
The more confident we are, the more such memories threaten our self-image. How can we be such good investors if we made those mistakes in the past? Instead of remembering the past accurately, in fact, we will remember it selectively so that it suits our needs and preserves our self-image.
Incorporating information in this way is a form of correcting for cognitive dissonance, a well-known theory in psychology. Cognitive dissonance posits that we are uncomfortable holding two seemingly disparate ideas, opinions, beliefs, attitudes, or in this case, behaviors, at once, and our psyche will somehow need to correct for this.
Correcting for a poor investment choice of the past, particularly if we see ourselves as skilled traders now, warrants selectively adjusting our memory of that poor investment choice. 'Perhaps it really wasn't such a bad decision selling that stock?' Or, 'Perhaps we didn't lose as much money as we thought?' Over time our memory of the event will likely not be accurate but will be well integrated into a whole picture of how we need to see ourselves.
Another type of selective memory is representativeness, which is a mental shortcut that causes us to give too much weight to recent evidence—such as short-term performance numbers—and too little weight to the evidence from the more distant past. As a result, we'll give too little weight to the real odds of an event happening.
3. Self-Handicapping
Researchers have also observed a behavior that could be considered the opposite of overconfidence. Self-handicapping bias occurs when we try to explain any possible future poor performance with a reason that may or may not be true.
An example of self-handicapping is when we say we're not feeling good prior to a presentation, so if the presentation doesn't go well, we'll have an explanation. Or it's when we confess to our ankle being sore just before running on the field for a big game. If we don't quite play well, maybe it's because our ankle was hurting.
As investors, we may also succumb to self-handicapping, perhaps by admitting that we didn't spend as much time researching a stock as we normally had done in the past, just in case the investment doesn't turn out quite as well as expected. Both overconfidence and self-handicapping behaviors are common among investors, but they aren't the only negative tendencies that can impact our overall investing success.
4. Loss Aversion
It's no secret, for example, that many investors will focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. This behavior is called loss aversion. Investors have been shown to be more likely to sell winning stocks in an effort to 'take some profits,' while at the same time not wanting to accept defeat in the case of the losers. Philip Fisher wrote in his excellent book Common Stocks and Uncommon Profits that, 'More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason.'
Regret also comes into play with loss aversion. It may lead us to be unable to distinguish between a bad decision and a bad outcome. We regret a bad outcome, such as a stretch of weak performance from a given stock, even if we chose the investment for all the right reasons. In this case, regret can lead us to make a bad sell decision, such as selling a solid company at a bottom instead of buying more. It also doesn't help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It's this unwillingness to accept the pain early that might cause us to 'ride losers too long' in the vain hope that they'll turn around and won't make us face the consequences of our decisions.
5. Sunk Costs
Another factor driving loss aversion is the sunk-cost fallacy. This theory states that we are unable to ignore the 'sunk costs' of a decision, even when those costs are unlikely to be recovered.
One example of this would be if we purchased expensive theater tickets only to learn before attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend. Rational behavior would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest. Instead, our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits. Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.
6. Anchoring
Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know—the population of the Big Apple—and adjust down, but not enough. Ask people in Milwaukee to guess the number of people in Chicago and they'll anchor on the number they know and go up, but not enough. When estimating the unknown, we cleave to what we know.
Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings or on last year's earnings. For investors, anchoring behavior manifests itself in placing undue emphasis on recent performance as this may be what instigated the investment decision in the first place.When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to 'break even' or get back to what we paid for it. We may cling to subpar companies for years rather than dumping them and getting on with our investment life. It's costly to hold on to losers, though, and we may miss out on putting those invested funds to better use.
7. Confirmation Bias
Another risk that stems from both overconfidence and anchoring involves how we look at information. Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favorably.
For instance, if we've had luck owning a certain brand’s cars, we will likely be more inclined to believe information that supports our own good experience owning them, rather than information to the contrary. If we've purchased a mutual fund concentrated in healthcare stocks, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.
Hindsight bias also plays off of overconfidence and anchoring behavior. This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome. Our judgment of a previous decision becomes biased to accommodate the new information. For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. This type of 'knowledge updating' can keep us from viewing past decisions as objectively as we should.
8. Mental Accounting
If you've ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Most of us separate our money into buckets—this money is for the kids' college education, this money is for our retirement, this money is for the house. Heaven forbid that we spend the house money on a vacation.
Investors derive some benefits from this behavior. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture. One example of this would be how we view a tax refund. While we might diligently place any extra money left over from our regular income into savings, we often view tax refunds as 'found money' to be spent more frivolously. Since tax refunds are in fact our earned income, they should not be considered this way.
For gambling aficionados this effect can be referred to as 'house money.' We're much more likely to take risks with house money than with our own. For example, if we go to the roulette table with $100 and win another $200, we're more likely to take a bigger risk with that $200 in winnings than we would if the money was our own to begin with. There's a perception that the money isn't really ours and wasn't earned, so it's OK to take more risk with it. This is risk we'd be unlikely to take if we'd spent time working for that $200 ourselves.
Similarly, if our taxes were correctly adjusted so that we received that refund in portions all year long as part of our regular paycheck, we might be less inclined to go out and impulsively purchase that Caribbean cruise or new television.
In investing, just remember that money is money, no matter whether the funds in a brokerage account are derived from hard-earned savings, an inheritance, or realized capital gains.
9. Framing Effect
The framing effect addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision. Let's assume, for example, that we decide to buy that television after all. But just before paying $500 for it, we realize it's $100 cheaper at a store down the street. In this case, we are quite likely to make that trip down the street and buy the less expensive television. If, however, we're buying a new set of living room furniture and the price tag is $5,000, we are unlikely to go down the street to the store selling it for $4,900. Why? Aren't we still saving $100?
Unfortunately, we tend to view the discount in relative, rather than absolute terms. When we were buying the television, we were saving 20% by going to the second shop, but when we were buying the living room furniture, we were saving only 2%. So it looks like $100 isn't always worth $100 depending on the situation.
The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, and to take care not to think of your 'budget buckets' so discretely that you fail to see how some seemingly small decisions can make a big impact.
10. Herding
There are thousands and thousands of stocks out there. Investors cannot know them all. In fact, it's a major endeavor to really know even a few of them. But people are bombarded with stock ideas from brokers, television, magazines, websites, and other places. Inevitably, some decide that the latest idea they've heard is a better idea than a stock they own (preferably one that's up, at least), and they make a trade.
Unfortunately, in many cases the stock has come to the public's attention because of its strong previous performance, not because of an improvement in the underlying business. Following a stock tip, under the assumption that others have more information, is a form of herding behavior.
This is not to say that investors should necessarily hold whatever investments they currently own. Some stocks should be sold, either because the underlying businesses have declined or their stock prices greatly exceed their intrinsic value. But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons.
We can all be much better investors when we learn to select stocks carefully and for the right reasons, and then actively block out the noise. Any temporary comfort derived from investing with the crowd or following a market guru can lead to fading performance or inappropriate investments for your particular goals.
This is for informational purposes only and should not be considered financial planning advice.
Diversification does not eliminate the risk of experiencing investment losses. Holding a portfolio of securities for the long-term does not ensure a profitable outcome, and investing in securities always involves risk of loss.
Returns and principal invested in stocks are not guaranteed, and stocks have been more volatile than other asset classes.

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