The Intelligent Investor — Appendixes 3

Interest and dividends are taxable as ordinary income except (a) income received from state, municipal, and similar obligations, which are free from Federal tax but may be subject to state tax, (b) dividends representing a return of capital, (c) certain dividends paid by investment companies (see below), and (d) the first $100 of ordinary domestic-corporation dividends.

Rule 2—Capital Gains and Losses

Short-term capital gains and losses are merged to obtain net short-term capital gain or loss. Long-term capital gains and losses are merged to obtain the net long-term capital gain or loss. If the net short-term capital gain exceeds the net long-term capital loss, 100 per cent of such excess shall be included in income. The maximum tax thereon is 25% up to $50,000 of such gains and 35% on the balance.

A net capital loss (the amount exceeding capital gains) is deductible from ordinary income to a maximum of $1,000 in the current year and in each of the next five years. Alternatively, unused losses may be applied at any time to offset capital gains. (Carry- overs of losses taken before 1970 are treated more liberally than later losses.)

Note Concerning “Regulated Investment Companies”

Most investment funds (“investment companies”) take advantage of special provisions of the tax law, which enable them to be taxed substantially as partnerships. Thus if they make long-term security profits they can distribute these as “capital-gain dividends,” which are reported by their shareholders in the same way as long-term gains. These carry a lower tax rate than ordinary dividends.

Alternatively, such a company may elect to pay the 25% tax for the account of its shareholders and then retain the balance of the capital gains without distributing them as capital-gain dividends.

3. The Basics of Investment Taxation (Updated as of 2003)

Interest and Dividends

Interest and dividends are taxed at your ordinary-income tax rate except (a) interest received from municipal bonds, which is free from Federal income tax but may be subject to state tax, (b) dividends representing a return of capital, and (c) long-term capital-gain distributions paid by mutual funds (see below). Private-activity municipal bonds, even within a mutual fund, may subject you to the Federal alternative minimum tax.

Capital Gains and Losses

Short-term capital gains and losses are merged to obtain net short-term capital gain or loss. Long-term capital gains and losses are merged to determine your net long-term capital gain or loss. If your net short-term capital gain exceeds the net long-term capital loss, that excess is counted as ordinary income. If there is a net long-term capital gain, it is taxed at the favorable capital gains rate, generally 20%—which will fall to 18% for investments purchased after December 31, 2000, and held for more than five years.

A net capital loss is deductible from ordinary income to a maximum of $3,000 in the current year. Any capital losses in excess of $3,000 may be applied in later tax years to offset future capital gains.

Mutual Funds

As “regulated investment companies,” nearly all mutual funds take advantage of special provisions of the tax law that exempt them from corporate income tax. After selling long-term holdings, mutual funds can distribute the profits as “capital-gain dividends,” which their shareholders treat as long-term gains. These are taxed at a lower rate (generally 20%) than ordinary dividends (up to 39%). You should generally avoid making large new investments during the fourth quarter of each year, when these capital-gain distributions are usually distributed; otherwise you will incur tax for a gain earned by the fund before you even owned it.