- How
are dividends taxed? Are they all taxed the same?
- What
are the tax consequences of reinvesting my dividends, if
any?
- How
does dividend reinvesting impact my taxes? How are dividends
that are reinvested taxed?
- Can
you recommend a good software package that will ease my
tax burden?
- What
tax form(s) do I receive and from whom?
- Do
you have any tricks and tips for keeping track of my cost
basis?
- If
I sell just part of my holdings in a particular stock, may
I use an "average cost" computation, just like I can with
my mutual funds?
- Whose
social security number do I submit on a custodial account,
and who pays the taxes?
- What's
the difference between short-term and long-term capital
gains? How do I know which one I should pay?
1.
How are dividends taxed? Are they all taxed the same?
That really depends on the dividends that you are talking
about. The annual 1099-DIV form that your company will send
you shows how much you received in dividend payments, even
if it all went to buy more stock. Report all dividends as
income on your annual tax return. The dividends are treated
as ordinary income and will be taxed at your marginal tax
rate. Pretty simple. It's much like reporting interest from
a savings account -- a one line entry. You report the dividends
you receive on Schedule B, which is used to record interest
and dividend income, but only if you receive more than $400
worth in one year. Otherwise, you simply report dividend income
on your main 1040 tax form.
Sometimes capital gains can appear where you least expect
them, like on a dividend statement related to a stock or mutual
fund that you own. It's good to look closely at the 1099-DIV
forms you receive to see if they say anything like "Capital
Gains Distribution" on them.
Most stock dividends are treated as normal, or ordinary, dividends
and don't count as capital gains -- and should be reported
directly on Schedule B. If your portfolio is pretty much all
stocks and no mutual fund shares, this section is unlikely
to apply to you. But let's review it, just in case.
If you see a "Capital Gains Distribution" mention on a 1099-DIV
statement that you receive, report those distributions directly
on Schedule D. Just a few years ago, those distributions were
required to first be reported on Schedule B (Interest and
Dividends). But no longer. Take your capital gains distributions
directly to Schedule D (Capital Gains and Losses).
Be aware that some companies don't send you the form 1099-DIV
when the dividend payments that you received for the year
amounted to less than $10. The dividends are still taxable,
however. Your year-end account statement will show the total
amount of dividends that you received. You should report that
number as income, just as if you'd received a 1099-DIV.
If you reinvest your dividends, either in mutual funds or
dividend reinvestment plans, things are just a little bit
trickier. You still pay tax on the dividends that are distributed
to you, and the shares purchased with dividends are accounted
for exactly as if you had bought them with money sitting in
your bank account. So you must keep the statements showing
your cost basis on dividend reinvestment-acquired shares just
as you do when you make optional cash payments to buy shares.
When it comes time to sell, you need to know the cost basis
for all of your shares -- those bought with reinvested dividends
and those bought separately with your hard-earned money.
Finally, one brief word about credit union "dividends": Be
careful if you receive a statement of "dividends" paid to
you by your credit union. What some credit unions call dividend
income is really interest. So even if it says dividend, treat
it as interest and include it with interest income.
Money market mutual funds may be a little confusing, as they
can generate both interest income and dividend income. You'll
need to pay attention to the statements they send you. Income
reported to you on a 1099-INT is interest income and on a
1099-DIV is dividend income.
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2. What are the tax consequences of reinvesting
my dividends, if any?
Again, the answer really depends on what dividends you are
really reinvesting. When you say "reinvestment," most people
immediately think of mutual funds. So let's look at those
first.
If you reinvest your dividends within a mutual fund, you are
really buying more shares of stock, at different times, and
at different prices. You are simply eliminating the middle
man: Instead of the mutual fund company sending you a dividend
check, and then you sending the mutual fund company that same
check to purchase more shares, the mutual fund company just
purchases the new shares directly. But make no mistake --
these are brand spankin' new shares that you have purchased.
You still need to pay tax on the dividends paid to you, and
you also need to update your tax basis in your mutual fund
in order to account for these additional purchases of shares.
If you're not updating your mutual fund cost basis for dividends
you receive and have reinvested back into a mutual fund in
the form of additional shares, you're going to end up being
taxed on them twice. This is a common mistake that many taxpayers
make. Reinvested dividends should be considered as additional
purchases of stock, at different prices.
And this is basically the same if you are talking about a
dividend reinvestment plan (or DRIP). You'll have to pay income
tax on the dividends that you receive that are directly invested
in brand new shares of stock. And you'll want to make sure
that you update your cost basis records with your additional
purchases from the dividends that you reinvest.
Does this sound like a lot of work? It certainly can be. But
if you don't do the work, you may find yourself paying WAY
too much in taxes when you finally decide to cash in your
mutual fund or DRIP shares.
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3. How does dividend reinvesting impact my
taxes? How are dividends that are reinvested taxed?
As we have pointed out above, when you reinvest your dividends,
you are really receiving a dividend and then buying additional
shares of stock. So you pay income tax on the dividends that
are paid to you, and the new shares that are purchased are
nothing more than capital assets, just like the original stock
purchased. If you hold these shares for a year or less before
you sell them, you'll pay taxes on any gains at your marginal
income tax bracket. But if you hold the shares for more than
one year, any gain that you realize will be taxed at the preferred
capital gains rates.
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4. Can
you recommend a good software package that will ease my tax
burden?
Recommend? Nope. But I can tell you that the main contenders
when it comes to tax preparation software are Intuit's TurboTax
and MacinTax, and Kiplinger's TaxCut. If you're the type who
loves filling out questionnaires and answering questions, you
might actually enjoy (gasp!) preparing your taxes this way.
It has many advantages:
- You
don't have to gather any forms; they're all in the program
already.
- You
can revise and revise and revise, without making a mess
with white-out or an eraser. Enter your information, see
what your tax liability is, and then you can make adjustments,
playing out different scenarios to see which is most cost-effective.
(You might see that it's smart to realize some capital gains
this year, for example.)
- The
software can assist you with decisions. It will ask you
questions and either make decisions for you (regarding which
forms to use, for example) or offer you some information
and ask you to make a choice.
- You
can pay less attention to details. Once the program has
certain information, it will make sure that it's carried
over to all required places. You don't have to worry about
that.
- Carryovers
from year to year get taken care of automatically - if you
used the same program to prepare your return last year.
There are,
of course, some disadvantages to electronic tax return preparation.
The main one is that you have to trust the software, even though
you're still the one responsible for filing your return. There's
always a small chance that the software could cause an error
- or that you provided an incorrect number and generated the
error yourself. (Of course, even manually prepared returns may
contain errors.)
Our best advice regarding tax preparation software is that you
try it - at least once. Consider using it as a cross-check for
yourself the first year. In other words, fill out your return
the old-fashioned way and then do it electronically. Compare
the results and you'll get a much better feeling for how accurate
and/or helpful the software is. You can choose whether you want
to file your original return or the computer-generated one,
and you'll probably have an idea of which approach to use the
following year.
Perhaps the most powerful advantage of tax preparation software
is that it lets you play "what if" games. Once you've entered
the necessary information, change one variable and see how the
bottom line is affected. See what will happen if you get a big
raise at work or if you sell some stocks for a sizable capital
gain. This can be enormously valuable if you think you might
have to pay estimated taxes. The software can help you figure
out whether or not you'll have to pay estimated taxes.
When buying tax preparation software, make sure that the package
includes state tax forms for your state if you'd like it to
prepare those forms, as well. Verify that it is indeed compatible
with your computer system. Make sure that it contains all the
forms you'll need. If you buy the software early in the year,
make sure you get an updated final version later in the year,
so that you're preparing your return incorporating the latest
information and tax code revisions. You can read more about
available software at the software company Web sites - and in
many cases, you can get demo versions there as well. Keep in
mind that you can often prepare your return online without even
buying the software -- by using a special Web site and paying
a fee online instead.
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5. What tax form(s) do I receive and from whom?
You'll generally receive a tax forms package from Uncle Sammy
right around the first of the year. That package will include
forms that the IRS feels that you might need, based on the forms
that you filed last year. If your tax return was prepared by
your accountant last year, it's likely that all that you'll
receive is a post card with your official IRS name and address
sticker. That post card will also allow you to order forms if
you so chose.
If you find that you need additional forms, your local public
library and/or post office will likely have some of the "main"
forms. But some of the more technical forms may not be found
there. If you find that you need additional forms, you can order
them from the IRS by calling 800-TAX-FORM (800-829-3676). You
can also download forms and instructions directly from the IRS Web site. You'll need
an Acrobat reader, but if you don't have one, you can download
one from the Web site at no cost.
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6. Do you have any tricks and tips for keeping
track of my cost basis? It seems that by investing on a monthly
basis and reinvesting the dividends I'm creating a nightmare
when I sell stock and have to determine my cost basis.
No real tricks, just hard work -- especially if you are doing
it by hand. You must simply learn how the tax laws work when
dealing with computing your cost basis in your shares, regardless
if the shares are in mutual funds or dividend reinvestment plans,
and then make the computations.
But, as you suggest, even if you understand this accounting
system completely, the paperwork can be a hassle. At the Fool
we use our Portfolio Tracker software to do all of the dirty
work for our real-money Drip Portfolio online. It's available
for a reasonable price from FoolMart. There are
also other computer programs that do the job, such as Quicken
from Intuit.
If you'd rather track your investments by hand, that's perfectly
acceptable and -- allow us to say -- even quite fanciful (maybe
turn off the power and light candles while working, too). Many
people track their direct investments in a ledger, much like
an accountant would in the good old days. One downside is that
it'll be difficult to track your actual performance because
share price accounting isn't automatic when using paper and
pencil. The choice is yours.
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7. If I sell just part of my holdings in a
particular stock, may I use an "average cost" computation, just
like I can with my mutual funds?
Nope. Sorry. When you are dealing with individual shares of
stock (and that would also apply to DRIP shares), you have only
two options when determining the basis (or cost, for tax purposes)
of shares. They are: Specific Identification Method
First In-First Out Method (FIFO)
First, the specific identification method:
Let's say that you made the following purchases:
June 1, 2000: 100 shares @
$10 each
June 5, 2000: 200 shares @
$11 each
June 10, 2000: 300 shares @ $13 each
The stock is now trading at $15 a stub. You decide you want
to sell 300 shares. You also know that you want to sell the
shares you originally bought on June 10, 2000. You very emphatically
tell your broker that those are the shares that you want to
sell, and not the 100 shares bought on June 1, nor the 200 bought
on June 5.
Why would you want to do this? Because of the tax implications.
If you sell the first 300 shares that you bought, your capital
gains will be $1,300 (not including commission adjustments).
But by selling the later shares, your capital gains only amount
to $600. That could be a tax saving of almost $280 - just by
making a simple decision and specifically identifying the shares
that you want to sell.
It's important to think about your current tax and income situation
and what you expect your situation to be in the next few years.
If you're getting out of school soon and expect that you'll
soon be in a higher tax bracket, you might want to sell the
earliest shares and take a bigger tax hit now. This might make
sense if you plan to have a much heftier salary next year and
perhaps expect that the stock will have appreciated considerably,
as well. On the other hand, if the last shares you bought have
not yet been held long enough to qualify for the lowest capital
gains tax rate, it might be worth it to sell the ones you've
held longer. Look at your options from many different perspectives
and see which one saves you the most money - both now and in
the long run.
If you decide to use the FIFO method (which is actually the
default method that you must use if you can't qualify for the
"specific share" method), the first securities you bought are
the first ones sold. The basis of the stock for capital gains
purposes is the cost of the first securities you purchased.
In the example above, using the FIFO method could very well
have cost you an additional $280 in tax dollars. For more details
on using the specific share method, click
here.
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8. Whose social security number do I submit
on a custodial account, and who pays the taxes?
Remember that while you (or someone else) may be the custodian
of this type of account, the account really belongs to the child.
The custodian is simply involved in managing the account, protecting
the assets in the account, and generating growth and/or income
within the account. Since the account belongs to the child,
so do any income or gains (and the associated taxes) generated
by the account. This is one reason that custodian accounts are
so very popular: The earnings and gains shift to the child and
are (usually) taxed at a lower rate. Because of this fact, the
tax return is filed by the child (or by the custodian on behalf
of the child), and the child's social security number is used
to report the income and gains.
But let's not forget the kiddie tax. While this income still
belongs to the child, some of it could very well be taxed at
your personal tax rate via the kiddie tax rules. Obviously,
having the child's income taxed at your individual tax rate
will cancel some of the tax benefits of establishing a custodian
account -- so it's something that you'll want to manage as carefully
as possible. For more on the kiddie tax, click
here.
It's very important to remember -- always -- that these funds
really do belong to the child. They aren't yours to do with
as you please. And when your child reaches the age of majority,
look out. Because the money is all his or hers, to do with as
they please. Let that thought haunt you for a few minutes.
(We pause to permit the haunting…)
Okay, now let's look at the various kinds of custodial accounts
that are out there. Two of the biggies are the UGMA and the
UTMA. "Ugma? Utma." Gee, that sounds like a caveman asking a
cave woman out on a date. Nevertheless, the Uniform Gift to
Minors Account and the Unified Transfers to Minors Account are
the two main types of custodial accounts that you'll see. And
if you are interested in establishing an custodial account,
it's virtually certain that you'll use one of these two account
types. Get all the information you'll need about investing for
your kids here.
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9. What's the difference between short-term
and long-term capital gains? How do I know which one I should
pay?
What rate applies to you specifically? Well, it all depends
on:
- the
type of asset you sold
- your
cost basis
- the
length of time you held the asset before selling it
- your
income level
Qualifying
for the lowest new rates are stocks, bonds, mutual funds, and
many other capital assets. Taxed at a slightly higher rate are
business or rental real estate, collectibles, depreciation,
and some other things. For this question, we'll be referring
to the rates and rules pertaining to securities investments.
There are two holding periods for capital assets sold. Assets
held for a year or less are considered short term. Those held
for more than one year are considered long term.
Here's the bottom line:
| If
you're in the 15% tax bracket: |
Assets
held for a year or less: Taxed at ordinary income tax
rate
Assets held for more than a year: 10% tax |
|
| If
your tax bracket is greater than 15%: |
Assets
held for a year or less: Taxed at ordinary income tax
rate
Assets held for more than a year: 20% tax |
Note that when you place an order to buy or sell a security
with your broker, there will be a "trade date" and "settlement
date" recorded for the order. Which one counts for tax purposes?
The trade date, which is the date that the order was executed.
(The settlement date is the date when the cash or securities
from the transaction are plunked into your account.)
But there's one very important point that you must understand
with respect to capital gains income. In effect, your capital
gains income is added to your regular income -- and it is on
that total income that you compute your "normal" tax bracket.
Then you're able to use Schedule D to compute your tax using
a preferred tax rate on your long-term capital gains. Please
don't think that if you have $100 in other income and $1 million
in long-term capital gains that you're in the 15% bracket, and
that all of your $1 million in long-term gains will be taxed
at the preferred 10% rate. It's just not true. You have to add
your $1 million to your $100 and then look at your tax bracket.
That would be considered "normal" for your income for that year
-- and you'll see that that amount would put you considerably
beyond the 15% bracket. So while some of your gain would be
taxed at the lower, preferred rates, the vast majority of the
income would be taxed at the 20% long-term capital gains rate.
You should also know that soon there will be even lower capital
gains tax rates for those who qualify for those rates. We call
them "Super Foolish Capital Gains Tax Rates." If you'd like
to learn a bit more about them and how you can plan for them
in the future, click
here.
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