Two clients. Same taxable account. Same $100,000 of income this year.
One writes a check to the IRS for roughly $24,000. The other writes a check for $0 — and the income disappears from their 1040.
Same dollars in. Completely different dollars out. Nothing about this is a loophole. It’s the tax code working exactly as written. The difference is what kind of income it was.
This is the part of after-tax yield that most models skip — and it’s the part that matters most.
Distribution is a number. Income has a character.
The IRS doesn’t see “distributions.” It sees categories. Every dollar that lands in a brokerage account is sorted into one of a handful of buckets, and the amount in each bucket decides the rate.
Ordinary income — bond interest, CD coupons, most money markets. Taxed at the top marginal rate, up to 37%.
Qualified dividends & long-term capital gains — preferential 0%, 15%, or 20% rate. On a top-bracket dollar, that’s roughly half the ordinary rate.
Section 1256 (the 60/40 rule) — certain index options and futures get a statutory blend: 60% long-term, 40% short-term, regardless of holding period. Blended top federal rate: ~27%.
Return of capital (ROC) — generally doesn’t appear as income on the 1040. It reduces cost basis and defers the tax until sale, which might be decades away, or never if basis steps up at death when passed to the next generation.
*ROC can create larger taxable gains at sale and cost basis can go to zero. Tax laws can change so there is no guarantee for future generations.
Two distributions can look identical on a brokerage statement and sit in completely different buckets on a 1099. Same distribution. Different tax universe.
The part no one models: the ripple
Here’s the “wow” moment.
Ordinary-income yield doesn’t just get taxed at a high rate. It raises Adjusted Gross Income, or AGI. And AGI is the domino that knocks over everything else, with the potential to:
- push the last dollars into the next federal bracket
- Trip the 3.8% Net Investment Income Tax
- Bump retirees into a worse IRMAA tier — raising Medicare premiums for a full year
- Increase the taxable share of Social Security (up to 85%)
- Phase out deductions and credits — QBI, education, child-related
- Layer on state tax at full ordinary rates
A client sitting in the 24% bracket who adds meaningful bond interest can find the marginal dollars taxed at 32% or 35% — plus the Net Investment Income Tax (NIIT), plus higher Medicare premiums next year, plus more of their Social Security now taxable. The headline tax rate understates the real drag by a wide margin.
Long-term capital gains and qualified dividends don’t do this. They sit on a parallel rate schedule and stack on top of ordinary income without pushing it up.
Return of capital doesn’t do it either — because, well, it isn’t income on the return.
The category is the whole game.
Add the wrapper
Income character is one lever. The wrapper is another, and the two compound.
Mutual funds are required to distribute their realized capital gains to shareholders every year. Investors get year-end capital gain distributions whether they asked for them or not — and owe tax on them whether they sold anything or not.
ETFs work differently. The in-kind creation/redemption mechanic lets the fund handle appreciated positions without triggering a taxable event inside the fund. Embedded gains stay embedded. The investor decides when to realize — not the fund.
Put it together: an ETF whose distributions are characterized primarily as Long-term capital gains or ROC, held in a taxable account, is a different after-tax product than a mutual fund throwing off ordinary income plus unwanted December capital gain distributions. Same shelf. Different planet.
The question to actually ask
Distribution is the easy number to compare. It’s also the wrong one.
For any income-oriented allocation in a taxable account, the more useful question is:
How is this going to show up on the 1099?
Ordinary income, and the client keeps maybe 60 cents of the dollar after federal, state, NIIT, and ripple effects. Long-term capital gain, and it’s closer to 80. Return of capital, and the tax can be deferred for years or erased entirely at step-up.
Same number on the brochure. Very different outcome in the bank account.
That’s the curtain worth pulling back.
Disclosure
This material is provided for informational and educational purposes only and should not be construed as tax, legal, or investment advice. Tax treatment depends on individual circumstances and current federal, state, and local tax rules, which are subject to change. Investors should consult their tax and financial advisers regarding their specific situation.