Income from Investments

Setting the sceneThe story we’ll use: the lemonade stand

Imagine a really popular lemonade stand called Sunny Lemonade. It’s so big that it’s owned by lots of kids, not just one.

To own part of Sunny Lemonade, you buy a slice of it. If the stand is cut into 100 slices and you own 1, you own 1/100 of the whole stand.

Grown-ups have official words for this:

Corporation

A big business like Sunny Lemonade (or just a company).

Share of stock

A slice of the company.

Shareholder

A person who owns slices (because they hold shares).

Securities

A fancy word for things like stocks and bonds that you can buy and sell. That’s why this kind of income is often called “income from securities.”

Now let’s learn the ways owning slices can make you money, and how the government taxes each one.

Part 1Dividends: sharing the profits

At the end of summer, Sunny Lemonade made lots of money after paying for lemons, sugar, and cups. That leftover money is called profit.

The stand decides to share some of the profit with everyone who owns a slice. If you own 1 slice, you get your share. That shared profit is called a dividend.

The big rule: Dividends count as income. That means the government gets to tax them.

Some dividends get a discount

The government gives some dividends a special lower tax, like a coupon. These are called qualified dividends. Depending on how much money you make, they’re taxed at only 0%, 15%, or 20%, which is usually less than the tax on a paycheck.

To get the coupon, two things have to be true:

1. The company is from the U.S., or from certain other countries the government approves.
2. You owned your slice long enough. You can’t just jump in right before the profits get shared and jump out right after. You have to own the slice for more than 60 days (around the time the dividend is paid). For a special kind of slice called preferred stock, it’s more than 90 days. (We’ll learn about preferred stock in Part 4.)

The profit jar

A company keeps track of all the profit it has made in something like a profit jar. The official name is earnings and profits. A real dividend has to come out of the profit jar.

But what if the company gives you money when the profit jar is empty? Then it’s not really sharing profits. It’s just giving you back some of the money you paid for your slice.

Here’s where a new word comes in: basis. Your basis is basically what you paid for your slice, like the price tag. Say you paid $10 for your slice. Your basis is $10.

So when the profit jar is empty, here’s what happens:

Why does the price tag matter? Because if you sell your slice later, the government taxes the difference between what you sell it for and your price tag. A smaller price tag means more profit to tax later.

Credit union “dividends” aren’t really dividends

A credit union is a lot like a bank. A savings and loan is another bank-like place. Sometimes they call the money they pay you a “dividend.” But it’s really just interest, the thank-you money for keeping your money there. So it does not get the special lower tax coupon.

Part 2Mutual funds: the big basket

Imagine you and 1,000 other kids each put in a few dollars, and one grown-up uses all that money to buy slices of lots of different lemonade stands, cookie stands, and toy stores. Now you all own a tiny piece of a giant basket of companies.

That basket is called a mutual fund. It’s a way to own a little bit of many companies at once.

When the basket makes money, it passes the money along to you. How it’s taxed depends on where the money came from, like checking the label on a juice box to see what’s inside:

• If the basket holds city and state IOUs (the muni bonds we learned about in Lesson 3.1), the money you get from them is tax-free interest.
• If the basket sold some slices for a profit, it passes that profit to you as a capital gain distribution. These are always treated as long-term, meaning they get the lower tax rate for things owned a long time, no matter how long you’ve owned your piece of the basket. Even if you joined the basket last week!

Profits the basket keeps

Sometimes the basket makes a profit but keeps it instead of giving it to you. The basket pays the tax on it itself. Even so, you still have to count your share as income, as if you got it.

Real estate investment trusts (REITs) can do this too. A REIT is like a mutual fund, but instead of owning slices of companies, it owns buildings, like apartments and shopping malls.

Tax rates for long-term capital gains can be 0%, 15%, 20%, 25%, or 28%, depending on the type of gain and how much money you make. Most regular stock profits use the first three. The higher 25% and 28% rates are for special kinds of things, which you’ll learn about later in the course.

Part 3Dividend reinvestment plans: trading candy for more slices

Imagine every time Sunny Lemonade shares its profits, instead of taking the money, you say, “Don’t give me the money. Use it to give me more slices instead!”

That’s a dividend reinvestment plan. (“Reinvest” means using money you earned to buy more of the same thing.)

Here’s the surprise: Even though you never got the money in your hand, it still counts as income.

The rules

• Buying slices at normal price: The dividend counts as income, just like normal.
• Buying slices at a discount (on sale): You count the full normal value of the slices you got, not the cheap price. If you got $20 worth of slices for $1, you count $20.
• Putting in extra money of your own to buy discounted slices: You count the difference between what you paid and what the slices are really worth.
• Fees count too: If the plan takes a little fee out of your dividend before buying slices, that fee still counts as dividend income. You got that money, and it just got spent on the fee.
• Your price tag: Your price tag (basis) for the new slices is their full normal value, even if you got them on sale. This is fair, because you already paid tax on that full value.

Three more rules

• Reinvested dividends are taxed in the year they’re paid.
• They get added to your price tag. So if you paid $100 for your first slices and reinvested $20, your total price tag is now $120. That means less tax when you sell later.
• They’re treated as regular (ordinary) dividends.

Part 4Stock dividends: cutting the pizza into more slices

Sometimes, instead of sharing money, a company gives you more slices of itself. This is called a stock dividend.

That’s why, usually, stock dividends are not taxed. You didn’t really get anything new. You still own the same share of the company.

Two kinds of slices

Before the exceptions, you need to know there are two kinds of slices:

Common stock

The regular kind of slice.

Preferred stock

A special slice that gets paid first when profits are shared, like getting to the front of the lunch line. In exchange, it usually doesn’t get a say in how the company is run.

The five exceptions: when stock dividends ARE taxed

The “same pizza, smaller slices” idea only works if everybody is treated the same. When things get uneven, someone really is getting more, so it gets taxed:

1. If anyone could pick cash instead. If the company says, “You can take new slices or money, your choice,” then all of the stock dividends are taxed, even for the kids who picked slices. That’s because they could have had money, so the slices are worth the same as money.
2. Some kids get cash, other kids get slices. If some owners get money and others get more slices, the kids getting slices now own a bigger piece of the pizza than before. They really did get more, so it’s taxed.
3. Some kids get special slices, other kids get regular slices. If some regular-slice owners get preferred slices (front-of-the-lunch-line slices), while others get regular slices, things aren’t even anymore. So it’s taxed.
4. Stock dividends on preferred slices. If the new slices are given out on preferred slices, they’re taxed. (There’s a small exception when the company is just adjusting things after a pizza re-slicing, which you don’t need to worry about much.)
5. Special slices that can turn into regular slices. Some preferred slices can be swapped for regular slices later. This is called convertible preferred stock. If a company hands these out and it ends up making things uneven, like in #2, they’re taxed.

Part 5Constructive dividends: the sneaky dividend

Imagine you own most of Sunny Lemonade, and you have the stand pay for your new video game. The stand isn’t calling it a dividend, but really, the stand just gave you some of its money.

When a company pays an owner’s personal bills, the government says, “That’s really a dividend in disguise.” It’s called a constructive dividend, and it’s taxed.

Part 6Stock options: the magic coupon

Now we get to some special perks that companies give their workers. These are a bit trickier, so let’s set up a new story.

Imagine you work at Sunny Lemonade, and your boss gives you a magic coupon. It says:

“Anytime in the next 5 years, you can buy 1 slice of Sunny Lemonade for $50, no matter what it costs at the time.”

That coupon is called a stock option. Here’s why it’s exciting: if Sunny Lemonade becomes super popular and a slice is worth $80 someday, you can still use your coupon and buy it for $50. You just saved $30! That savings is called the bargain element, meaning how good a deal you got.

Here are three words to remember:

Grant

When the boss gives you the coupon.

Exercise

When you use the coupon to buy the slice.

Sell

When you later sell the slice to someone else.

The big question is: when does the government tax you, and how much? It depends on what kind of coupon you have. Some coupons follow special rules written in the tax law, which give you a better deal. Others don’t.

Before we start, two more words:

Ordinary income

Taxed like a regular paycheck, at the regular (higher) rates.

Capital gain

Profit from selling something. Owned more than 1 year: long-term, lower tax rate. Owned 1 year or less: short-term, taxed like ordinary income.

So in general, you’d rather have long-term capital gain than ordinary income.

Part 7Nonstatutory stock options: the regular coupon

“Nonstatutory” just means “not covered by a special rule in the law.” These are regular coupons with no special tax deal.

Regular coupons can be taxed at different moments:

• When you get the coupon
• When you use the coupon
• When you sell the coupon
• When the rules stop blocking you from selling the slices you bought

Which moment it is depends on one question: can anyone easily tell what the coupon itself is worth on the day you get it? (The official phrase is “readily ascertainable fair market value.”)

• If yes, its value is easy to figure out: You’re taxed on the coupon’s value as pay, either when you’re allowed to give the coupon to someone else, or when there’s no longer a real chance you could lose it. (For example, some coupons get taken back if you quit your job too soon. Once that can’t happen anymore, it counts.)
• If no, nobody can easily tell what it’s worth (the most common situation): You’re taxed when you have a for-sure right to get the slice, usually when you use the coupon. The bargain, meaning the slice’s real value minus what you paid, counts as pay.

Part 8Incentive stock options: the special coupon

Incentive stock options (ISOs) are special coupons that follow rules in the tax law, so they get a better deal.

The good news: You usually don’t pay regular income tax when you get the coupon, or even when you use it.

The waiting rule: To get the best deal, you have to be patient and keep your slices for a while. You have to sell:

• At least 2 years after you got the coupon, and
• At least 1 year after you used the coupon.

If you wait long enough: All your profit is long-term capital gain, which has the lowest tax. But the company doesn’t get to take a deduction.

If you sell too early: You lose part of the deal. The bargain you got when you used the coupon (the slice’s value that day minus what you paid) becomes ordinary income, like pay, in the year you sell. The company does get to deduct that amount. Any extra profit after that is a capital gain (short-term or long-term, depending on how long you held the slices).

Part 9Nonqualified stock options: another regular coupon

A nonqualified stock option is a coupon that doesn’t follow all the strict rules for the special incentive coupon. So it doesn’t get the special deal. It’s taxed one of two ways, again depending on whether you can easily tell what the coupon is worth when you get it.

If you CAN tell what the coupon is worth when you get it

• You count the coupon’s value as income right when you get it.
• The company gets a deduction.
• Nothing happens when you use the coupon.
• When you sell the slices, you have a capital gain or loss.

If you CAN’T tell what it’s worth (most common)

• When you use the coupon, the bargain (slice’s value minus what you paid) counts as income.
• The company gets a matching deduction.
• Your price tag for the slices is what you paid plus the amount you were taxed on. (That’s the same as what happened to Maya in Part 7.)

Part 10Employee stock purchase plans: the worker discount

An employee stock purchase plan (ESPP) is a program that lets workers buy slices of their company at a discount, like an employee discount at a store.

The good news: You don’t pay any tax when you get the right to buy. You wait until you sell the slices.

When you sell (after waiting long enough)

If you keep the slices long enough (the same waiting rule as before: 2 years after getting the right to buy, and 1 year after buying), here’s how it’s taxed:

• Part of it is ordinary income: the discount you got based on the slice’s value when you first got the right to buy. That’s the value back then minus what you paid.
• The rest is capital gain.
• If the slices lost value: If you sell for less than the slices were worth when you got the right to buy, the ordinary income is limited to the sale price minus what you paid. That keeps it fair.

The rules of the plan

A plan has to follow these rules to get the special treatment:

• Only workers can be in it.
• The company’s owners (shareholders) have to vote yes on it within 12 months before or after the plan starts.
• The discount can’t be bigger than 15%. The price can’t be lower than 85% of the slice’s value, using whichever is smaller: the value when you got the right to buy, or the value when you bought.
• Time limits: If the price is at least 85% of the slice’s value when you buy, you have up to 5 years to buy. If the price is set some other way, you only have 27 months.
• No big owners: People who own 5% or more of the company can’t be in it. (It’s for regular workers, not the bosses who already own a lot.)
• Spending limit: No worker can buy more than $25,000 of slices in a year.
• No sharing: You can’t give your right to buy to someone else. Only you can use it. (The only exception is if you die and it passes to your family.)

The pay part

If you paid less than what the slice was worth when you got the right to buy, part of your deal counts as pay when you sell (or if you die and your slices pass to your family). The pay amount is the smaller of these two:

(value when you got the right to buy − the option price)
or
(value when you sell − what you paid)

That pay amount gets added to your price tag, so you aren’t taxed on it twice. The company does not get a deduction for this.

Wrap-upThe whole lesson in one picture

The stock option cheat sheet