As tax season draws nearer, advisors and investors increasingly look to their portfolio to optimize taxation. Given the surge of flows into short-term investments in the last year and a half, understanding the tax implications of these various assets may allow for better portfolio optimization and opportunity.
Understanding Income Taxation
Short-term capital gains (income earned on assets held one year or less) are taxed at ordinary income levels at the federal and state level. Some states do not have individual income taxes, but most do, with rates varying from 2.5% for those in the highest tax bracket, all the way to 13.3%.
Image source: Tax Foundation
Long-term capital gains (gains made on assets held for greater than a year) receive favorable taxation at the federal level. Capital gains made on these long-term investments are taxed at either 0%, 15%, or 20%.
States handle long-term capital gains differently. Thirty-two states tax long-term capital gains at ordinary income rates, while two (Washington and Minnesota) tax it at a higher rate than ordinary income, according to Tax Foundation. Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, and Wisconsin tax long-term capital gains at a lower rate. Seven states do not have individual income taxes.
Image source: Tax Foundation
Short-Term Investment Taxation
Many investors piled into money market funds in the last two years, seeking to capture elevated yields with low risk. However, those investments may prove surprising come tax season.
Money markets invest in a variety of assets, including Treasurys, CDs, short-term corporate bonds, and more. Some money market funds qualify as tax-exempt, investing in municipal bonds that offer exemption at the federal level but not necessarily the state. Other money market funds are taxable, with income earned taxed at relevant rates.
Other short-term investments with income taxed at normal federal and state/local rates include corporate bonds and CDs. Government bonds and Treasurys offer varying types of tax breaks, such as a federal exemption for municipal bonds.
Treasury bills (maturities of one year or less) offer a different taxation profile for investors. These hold appeal for their low-risk profile, particularly in times of ongoing volatility. Interest earned is taxed at the federal level, but T-bills are exempt from taxes at the state and local level. This may result in notable savings, depending on where an investor lives.
Enhanced Tax Efficiency in Short-Term Investments With CSHI
The NEOS Enhanced Income 1-3 Month T-Bill ETF (CSHI) offers enhanced, tax-efficient income within cash alternatives. The fund seeks to deliver 100-150 basis points above what one- to three-month T-bills are yielding. CSHI currently has a distribution yield of 5.55% and a 30-day SEC yield of 4.90% as of 7/31/2024.
CSHI seeks to generate high monthly income with its options-based strategy. It is long on three-month Treasury bills and sells out-of-the-money SPX Index put spreads. These roll weekly to account for market changes and volatility.
In addition to the taxation benefits of Treasury bills, the fund also uses S&P 500 index options. These options are taxed favorably as Section 1256 Contracts under IRS rules. This means the options held at the end of the year are treated as if sold on the last market day of the year at fair market value.
Any capital gains or losses are taxed as 60% long-term and 40% short-term. Notably, this tax treatment applies regardless of how long the portfolio held the options, thereby offering noteworthy tax advantages.
A portion of CSHI’s distributions also qualify as return of capital. These distributions are a return of some (or all) of the original investment made into an asset. In the case of options strategies such as CSHI, this often means a return on premiums earned by an investment as opposed to principal.
The fund’s managers also may engage in tax-loss harvesting opportunities throughout the year on the put options. CSHI has an expense ratio of 0.38%.
For more news, information, and analysis, visit the Tax-Efficient Income Channel.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
More Direct Indexing Topics >
