2. Capital gains refers to income that results from the appreciation of a capital asset (i.e. stocks, real estate, coins). Capital gains are not "realized" until the asset is sold. Ordinary income earners pay capital gains tax at a rate of 15%. High income earners pay 20%. Capital gains are classified as short-term or long-term.

Short-term capital gains are assets held for 12 months or less and are taxed at ordinary income rates.

Long-term capital gains are assets held for longer than 12 months and are taxed at reduced tax rates (based on the taxpayer's marginal tax bracket).

3. Dividends were taxed at ordinary income rates until 2003. Due to the change in tax law, "qualified stock dividends" (both common and preferred) are now taxed like capital gains are, with a maximum income tax rate of 15%. REIT dividends do not qualify for this special treatment.

4. Passive income is income from sources such as RELPS. Passive income could also be directly owned (but professionally managed) real estate, and is taxable at ordinary income rates. Rates can only be reduced by passive losses and not by capital gain losses.

MUTUAL FUND DISTRIBUTION AND TAXATION (the company itself)

Mutual funds are regulated investment companies under the Internal Revenue Code Subchapter M. Under this subchapter, the mutual fund itself does not pay taxes on investment income, dividends, or capital gains. Instead, the mutual fund serves as a conduit to the mutual fund investors. To qualify for this tax break, the investment company must register under the Investment Company Act of 1940 and distribute all (90% or more) of its net investment income to its shareholders. Ninety percent of the fund's income must come from dividends, interest, and capital gains from the portfolio's securities. At least 50% of the fund must be invested in diversified securities.

Capital gains distributions may only be made once a year and 98% of capital gain net income must be distributed to shareholders. Failure to do so will result in a 4% tax on the undistributed income. These distributions are long-term capital gains (income from securities sales held for longer than a year). Short-term capital gains (income from securities sales held less than a year) are distributed along the dividends.

Gross investment income is the total amount of dividend and interest earned by the securities in the fund.

Net investment income is calculated by deducting operating expenses (taxes, legal and management fees) from gross investment income.

Net dividend income is calculated by subtracting the mutual fund's expenses from the investment income received. The fund (company) will determine how often net dividend income will be distributed to its investors. Many fund companies will only distribute on a monthly basis.

MUTUAL FUND DISTRIBUTION AND TAXATION (the investors)

Investors receive two types of earnings from investment company shares. Dividends and interest from the securities held in the fund portfolio are the first type of earning. Capital gains are the second type. These capitals gains are a profit from the sale of securities in the portfolio.

Investment income can be reinvested in the fund or paid in cash to the investor. Either way, it is taxable as ordinary income according to the investor's marginal tax bracket. However, qualified dividends are taxable at a maximum rate of 15% for ordinary income earners.

Capital gains are paid out when the portfolio manager makes sales in the fund portfolio or when the investor redeems shares of the fund at a capital gain (just like he would by selling a stock for a profit).

When selling the shares of a mutual fund, the rates that were just discussed must be considered when calculating for taxes that might be imposed.

The holding period begins the day after the security is purchased (not the settlement date). This period ends on the sales day. If shares were purchased on more than one date, there are different ways to calculate the cost basis of the shares sold. Examples are as follows:

Specific identification: the investor may choose specific shares in order to minimize or maximize the cost basis (and therefore, capital gains or losses)

First-in/first-out: if the investor did not specify which shares were sold, the IRS presumes that the shares held the longest were sold first

Average share cost: this method is used when selling all the shares at once

CALCULATING GAINS AND LOSSES

Cost basis is a key concept to understand when computing gains and losses. Capital gains are taxed by subtracting the investor's cost from the sales proceeds. To determine the cost basis of an investment, start with the original price (plus any transaction costs) and add the dollar value of dividends that were reinvested. This applies to both stocks in a dividend-reinvestment program and to mutual funds where dividends are automatically reinvested. Reinvested capital gains are also added to the cost basis of mutual funds. The "basis" is the amount that has been invested in an asset. When someone inherits an investment, his cost basis is the value of the asset on the date the person died. This is known as stepped-up cost basis. The holding period is always long-term, even if the deceased had not owned the investment for 12 months before death.

If you receive an investment as a gift, there are actually two different cost bases that apply.
The two cost bases are actual cost basis of the giver and the market value on the date of the gift.

For example, John is given shares of a mutual fund as a gift.
The original owner's cost basis was $70 per share.
On the date the gift was given, the shares were trading at $60.
If John sells the shares in the future, then the basis for a gain is $70 a share, and the basis for a loss is $60.
If you sell the shares for a price between $60 and $70, you have neither a taxable gain nor a taxable loss.

Netting capital gains and losses-- If an investor makes several trades in one year, the result could be a mix of long-term and short-term capital gains and losses. The IRS specifies how these gains and losses should netted against each other. The following are examples:

Net short-term gains against net short-term losses

Net long-term gains against Net long-term losses

If both holding periods result in gains or losses, they are reported separately (Schedule D Form)

If one holding period results in a gain and the other in a loss, then they are netted against each other

If capital losses exceed capital gains, up to $3,000 ($1,500 if married filing separately) can be deducted against ordinary income in any one year

Unused capital losses can be carried forward indefinitely to future years (each year, unused capital losses will first be netted against the current year's capital gains, followed by the $3,000 deduction against ordinary income)

An exchange is the act of an investor moving shares of one mutual fund to another within the same mutual fund family. Even though a sale has not truly occurred, the IRS does consider an exchange to be a sale. Therefore, capital gains must be calculated and taxes must be paid. The cost basis of the new shares is simply the net asset value of the shares that were purchased.

A wash sale occurs when an investor sells a security at a loss, and then buys a similar (or same) security within a 30-day period. The same rule applies to the reverse scenario as well. In other words, if an investor purchases a security and then sells a similar security at a loss within a 30-day period, the sale is referred to as a wash. It is called this because the IRS will not make the investor take the loss if the buying and selling of the same or similar security occurred within 30 days. An investor usually does this when the value of a security has gone down. His intention is usually to sell it and then buy it back once its value has risen.

TAXATION OF VARIABLE ANNUITY CONTRACTS

Earnings-- While annuities are in the accumulation phase, no taxes are due on the earnings. All dividends, interest, and capital gains are automatically reinvested without incurring any local, state, or federal taxes. However, once they are withdrawn, all earnings are taxed as ordinary income.

Withdrawals-- If an investor withdraws from an annuity prior to age 59 ½, a 10% tax penalty will be imposed on the earnings. Similar to the exceptions for IRAs, there are also exceptions to this penalty (i.e. withdrawals due to death, disability, etc).

Annuity withdrawals are taxed on a “last-in/first-out” ("LIFO") basis. Therefore, earnings are taxed first as ordinary income, and any amount in excess of earnings is taken from the principal amount and is nontaxable. This applies when withdrawing lump-sum amounts. However, whether you take out one of the lifetime payouts or a payout over a specific number of years, the withdrawals will obviously be taxed (just differently). Each payment is considered one part principal (non-taxable) and one part rate of interest (taxable). Each payment is adjusted by an exclusion ratio. This ratio describes the relationship between the invested amount and the total expected return under the annuity contract.

Contract exchanges-- Section 1035 of the U.S. tax code permits an owner of an annuity to exchange an existing contract for a new one without paying any taxes on the income and investment gains in the current account. The process is a direct transfer from one custodian to another. Section 1035 tax-free exchanges are permitted for life insurance policies and annuities.

TAXATION OF VARIABLE LIFE INSURANCE

Earnings from a variable life policy are tax-deferred until withdrawn. Then, the earnings are taxed only to the extent at which they exceed the premiums the investor paid into the policy. However, when death benefits are payed out following a policyholder's death, the cash value will be included in the owner's gross estate and is not taxed as ordinary income.

Policy loans are permitted from variable life insurance policies. Money is allowed to be withdrawn from the contract without triggering income taxes on the policy's earnings.