Tag Archives: Dividends

FI Tax Strategies For Beginners

New to financial independence (FI or FIRE)? Are you steeped in financial independence, but confused about tax optimization?

If so, this is the post for you. It’s not “comprehensive tax planning for FI” but rather an initial primer on some basic financial independence tax planning tactics.

But first, a caveat: none of this is advice for your specific situation, but rather, this comprises a list of the top four moves I believe those pursuing financial independence should consider. No blog post (this one included) is a substitute for your own and your advisors’ analysis and judgment of your own situation.

ONE: Contribute Ten Percent to Your Workplace Retirement Plan

To start, your top retirement savings priority in retirement should be to contribute at least 10 percent of your salary to your workplace retirement plan (401(k), 403(b), 457, etc.). I say this for several reasons.

It starts a great savings habit.
Subject to vesting requirements, it practically guarantees that you will get the employer match your 401(k) has, if any.
Assuming a traditional retirement account contribution, it gets you a valuable tax deduction at your marginal tax rate.
It will be incredibly difficult to get to financial independence without saving at least 10 percent of your salary.

Here are some additional considerations.

Traditional or Roth

In some plans, the employee does not have a choice – employee contributions are “traditional” deductible contributions. Increasingly, plans are offering the Roth option where the contribution is not deductible today, but the contribution and its growth/earnings are tax-free in the future.

This post addresses the traditional versus Roth issue. I strongly favor traditional 401(k) contributions over Roth 401(k) contributions for most people. The “secret” is that most people pay much more in tax during their working years than they do during their retired years (even if they have significant balances in their traditional retirement accounts). Thus, it makes more sense to take the tax deduction when taxes are highest and pay the tax when taxes tend to be much lower (retirement).

Bad Investments

I’d argue that most people with bad investments and/or high fees in their 401(k) should still contribute to it. Why? First, consider the incredible benefits discussed above. Second, you’re probably not going to be at that job too long anyway. In this video, I discuss that the average/median employee tenure is under 5 years. When one leaves a job, they can roll a 401(k) out of the 401(k) to the new employer’s 401(k) or a traditional IRA and get access to better investment choices and lower fees.

Resource

Your workplace retirement plan should have a PDF document called a “Summary Plan Description” available in your workplace benefits online portal. Reviewing that document will help you figure out the contours of your 401(k) or other workplace retirement plan.

TWO: Establish a Roth IRA

For a primer on Roth IRAs, please read my Ode to the Roth IRA. Roth IRAs, like traditional IRAs, are “individual.” You establish one with a financial institution separate from your employer.

Generally speaking, a Roth IRA gives you tax-free growth, and if done correctly, money withdrawn from a Roth IRA is both tax and penalty free.

Roth IRA contributions can be withdrawn tax and penalty free at any time for any reason! The Roth IRA is the only retirement account that offers unfettered, tax-free access to prior contributions. Note, however, in most cases the best Roth IRA strategy is to keep money in the Roth IRA for as long as possible (so it continues to grow tax free!).

Find out why the Roth IRA might be much better than a Roth 401(k).

THREE: Contribute to an HSA

A health savings account is a very powerful saving vehicle. You have access to it if you have a high deductible health plan. To have an HDHP through your employer, you need to determine (i) if your employer offers a HDHP and (ii) whether the HDHP is appropriate medical insurance for you.

If you do not have employer provided insurance, you may be able to obtain an HDHP in the individual marketplace.

HSA contributions have several benefits. You receive an upfront income tax deduction for the money you contribute. If the funds in your HSA are used to pay qualified medical expenses, or are used to reimburse you for qualified medical expenses, the contributions and the earnings/growth are tax-free when paid out of the HSA. This tax-friendly combination means the HSA should be a high priority.

Here are a few additional considerations:

HDHP Benefit

I believe the HDHP is itself a great benefit in addition to the HSA. Why? One reason is that the HDHP reduces a known expense: medical insurance premiums! Why pay significant premiums for a low deductible plan when the point of medical insurance is not “coverage” but rather to avoid financial calamity in the event of injury or illness?

Dr. Suneel Dhand has a great YouTube channel. He has stated that as a doctor he is quite leery about getting treated for disease by Western medicine. I believe that is a very fair critique.

We over-medicalize our problems. Too often we run to the doctor looking for a solution when the answer lies in what we’re eating and/or our environment. We should work to avoid disease and doctor visits by taking control of our own health. That is very much in line with both the high deductible model of medical insurance and financial independence.

Part of “independence” (including financial independence) is questioning established systems. I am glad Dr. Dhand and others are starting to do just that when it comes to medicine. HDHPs help us do that while providing financial protection in the event of significant injury or illness.

Thinking about a future mini-retirement? One great way to lay the foundation today for tomorrow’s mini-retirement is to increase one’s financial independence from the medical system and decrease dependence on any one employer’s medical insurance.

State Income Taxes

In California and New Jersey, HSAs are treated as taxable accounts. Thus, in these states there are no state income tax deductions for contributions to an HSA. Furthermore, dividends, interest and other realized income and gains generated by HSA assets are subject to state income taxes. While detrimental, the federal income tax benefits are so powerful that even residents of these states should prioritize HSA contributions.

Employer Contributions

Check to see if your employer offers an employer contribution to your HSA. Many do. When the employer does, the employee leaves free money on the table if they do not enroll in the HDHP.

Reimbursements

In most cases, it is advisable to (i) pay current medical costs out of your own pocket (your checking account and other taxable accounts) and (ii) record and track these medical expenses. Leaving the money in the HSA during our working years allows it to grow tax-free!

Years later when the money has grown, you can reimburse yourself tax-free from your HSA for the Previously Unreimbursed Qualified Medical Expenses (PUQME), as there is no time limit on reimbursements. Note that only qualified medical expenses incurred after you first open the HSA are eligible for tax-free reimbursement.

FOUR: Save, Save, Save!!!

My last recommendation is simple: save, save, save! Are there ways to do it in a tax-efficient manner? Absolutely! But the absolute most important consideration is the act of saving and investing itself. Between retirement plans, lack of a payroll tax, and favored dividend and capital gain tax rates, saving and investing are often tax efficient without trying to be.

If in doubt, traditional 401(k) contributions are often fantastic.

Conclusion

Here are the top four tax moves I believe FI beginners should consider:

First, contribute 10 percent to your 401(k) or other workplace retirement plan

Second, establish a Roth IRA

Third, establish an HSA

Fourth, Save, Save, Save

Of course, this post is not tailored for any particular taxpayer. Please consult with your own tax advisor(s) regarding your own tax matters.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Subscribe to my YouTube Channel: @SeanMullaneyVideos

Follow me on X: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, medical, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, medical, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Two New Personal Finance Videos

To celebrate my new YouTube Channel’s one month anniversary, I posted two new videos this weekend. Enjoy!

Current events can inspire personal finance content creation. But should they change your financial plan?

Exploring the tax consequences of owning VTIAX.

You may notice some new background art, which I purchased from the StolitronArtDesign Etsy store.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post, and all videos, text, and comments on my YouTube channel, are for entertainment and educational purposes only. They do not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

What are Section 199A Dividends?

Did you receive a Form 1099-DIV which lists an amount in Box 5 “Section 199A dividends”? If so, you might be asking, what the heck are Section 199A dividends?

You probably never came across the term “Section 199A dividends” in high school algebra. That’s okay. Below I discuss what a Section 199A dividend is and how to report it on your tax return.

Watch me discuss how Section 199A Dividends are reported on tax returns.

Who Pays Section 199A Dividends?

Real estate investment trusts (“REITs”) pay Section 199A dividends. REITs are a special type of business entity. A REIT owns almost entirely real estate. Many office buildings, hotels, hospitals, malls, and apartment buildings are owned by REITs. Investors can own the stock of a single REIT, or they can own mutual funds or ETFs that are partly or entirely composed of REIT stock. For example, there are some REITs in the Vanguard Total Stock Market Index Fund (VTSAX).

REITs are advantageous from a tax perspective. In exchange for paying 90 plus percent of its income out to investors as dividends, the REIT itself does not pay federal corporate income taxes. This results in REITs often paying higher dividends than companies in other industries. The dividends paid by the REIT are Section 199A dividends.

I discuss the Section 199A dividends paid by VTSAX in this video.

What is the Tax Benefit of a Section 199A Dividend?

A Section 199A dividend qualifies for the Section 199A qualified business income deduction. This is also referred to as the QBI deduction. The qualified business income deduction is a 20 percent federal income tax deduction.

Here is an example of how the tax deduction works for Section 199A dividends.

Catherine owns shares of ABC REIT Mutual Fund. The mutual fund pays her $1,000.00 of dividends, all of which are Section 199A dividends reported to her in both Box 1a and Box 5 of Form 1099-DIV. She gets a $200 qualified business income deduction on her federal tax return (20 percent of $1,000.00) because of the $1,000.00 of Section 199A dividend.

There are several things to keep in mind when considering Section 199A dividends:

Section 199A dividends are a slice of the pie of dividends. The full pie of dividends, “total ordinary dividends,” is reported in Box 1a of Form 1099-DIV. Since Box 1a reports all of the dividends, Box 5 must be equal to or less than Box 1a.

There is no income limit (taxable income, MAGI, or otherwise) on the ability to claim the Section 199A qualified business income deduction for Section 199A dividends. The QBI deduction for self-employment income is generally subject to taxable income limitations on the ability to claim the deduction. Not so with the Section 199A dividends. Taxpayers can claim the QBI deduction for Section 199A dividends regardless of their level of income.

Taxpayers get the Section 199A QBI deduction regardless of whether they claim the standard deduction or itemized deductions.

There is no requirement to be engaged in a qualified trade or business to claim the QBI deduction for Section 199A dividends.

The QBI deduction does not reduce adjusted gross income. Thus, it does not help a taxpayer qualify for many tax benefits, such as the ability to make an annual contribution to a Roth IRA.

Section 199A dividends are not qualified dividends (which are reported in Box 1b of Form 1099-DIV). They are taxed as ordinary income subject to the taxpayer’s ordinary income tax rates. They do not qualify for the preferred federal income tax rates for qualified dividends.

Where Do I Report a Section 199A Dividend on My Tax Return?

Section 199A dividends create tax return reporting in three prominent places on a federal income tax return.

First, Form 1099-DIV Box 1a total ordinary dividends are reported on Form 1040 Line 3b. As Section 199A dividends are a component of Box 1a total ordinary dividends, they are thus reported on the Form 1040 on Line 3b. Section 199A dividends are not reported on Line 3a of Form 1040 because Section 199A dividends are not qualified dividends.

Second, Section 199A dividends are reported on either Line 6 of Form 8995 or Line 28 of Form 8995-A. In most cases, taxpayers will file the simpler Form 8995 to report qualified business income and Section 199A dividends. By reporting Section 199A dividends on one of those lines most tax return preparation software should flow the dividends through the rest of the form as appropriate (but it never hurts to double check).

Third, the QBI deduction, computed on either Form 8995 or Form 8995-A, is claimed on Line 13 of Form 1040.

Tax return software varies. Hopefully, by entering the Form 1099-DIV in full in the software’s Form 1099-DIV input form, all of the above will be generated. Ultimately, it is up to the taxpayer to review the return to ensure that the information has been properly input and properly reported on the tax return.

Conclusion

Section 199A dividends create a taxpayer favorable federal income tax deduction. They are reported in Box 5 of Form 1099-DIV and should be reported on a taxpayer’s federal income tax return.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on X at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

From Tax Returns to Tax Planning

Many colloquially refer to the Winter and early Spring as “tax season.” To my mind, that is short sighted. Yes, for most the time from late January to mid-April are when their tax return is prepared and filed. But the most impactful tax work is not tax return preparation — it’s tax planning!

Below I discuss ways to use your current tax return as a springboard to tax planning.

Before we get started, two notes. First, there is some tax planning that can be “do it yourself” and some tax planning that is best considered and implemented with the help of a tax planning professional. When in doubt, the concept is probably the latter. Second, it is helpful to keep in mind the correct use of this blog or any other blog–as a tool to raise awareness. Blogs are not a substitute for professional advice, and are not advice for any particular person. Rather, this post and others should be viewed as a way to increase knowledge and help faciliate more informed conversations with professionals.

Your 2020 Tax Return

Your 2020 tax return is a great springboard for tax planning. Look at the following items on your tax return to jump start your tax planning.

Schedule D Line 13 Capital Gain Distributions

Everyone should review their own tax returns for the past few years and look at this line. If there is a substantial number on this line, it should raise a red flag.

I previously discussed capital gain distributions here. Generally, they come from mutual funds and ETFs in taxable accounts. These financial securities pass gains out to the shareholders, creating capital gains income on the shareholders’ tax returns. Actively managed funds tend to have much greater capital gain distributions than passively managed index funds.

The planning opportunity is to review the accounts that are generating significant capital gain distributions. If the realized gain in such accounts is low (or if there is a realized loss in those accounts), it might be advisable to sell the holding and replace it with a fund likely to have lower capital gain distributions. Taxpayers considering this strategy should be sure to fully understand the gain or loss in the securities before selling. Financial institutions do not have to report to investors (and the IRS) basis in mutual funds purchased prior to 2012, so sometimes it can be difficult to determine the taxable built-in gain or loss on older holdings.

Form 8889 Line 14c Distributions

Form 8889 is the tax return form for a FI favorite: the health savings account. Amounts other than $0 on Line 14c of Form 8889 should appear, in my opinion, only if the taxpayer is elderly or found themselves in a dire situation during the tax year. It is generally not optimal, from a tax perspective, to take distributions from an HSA to fund medical expenses when one is neither elder nor in a dire situation.

Amounts other than $0 on Line 14c can be a learning and planning opportunity. Future routine medical expenses are usually best paid from one’s checking account (a regular taxable account), and taxpayers should save the receipt. In the future, taxpayers can reimburse themselves tax free from their HSA for that expense. In the meantime, the money has grown in the HSA and enjoyed many years of tax free compounding.

Form 1040 Line 4b IRA Distributions Taxable Amount

Taxpayers who did a Backdoor Roth IRA and have a large amount on Line 4b of Form 1040 should review their transactions to make sure everything was correctly reported. Part of the idea behind a Backdoor Roth IRA is that, if properly executed, it should result in a very small amount of taxable income (as indicated on Line 4b).

It may be the case that the tax return improperly reported the Backdoor Roth IRA (and thus, the taxpayer should amend their return to obtain a refund). Or, it may be the case that the taxpayer did the steps of the Backdoor Roth IRA at a time they probably should not have (because they had a significant balance in a traditional IRA, SEP IRA, or SIMPLE IRA).

Discovering the problem can help effectively plan in the future, and if necessary take corrective action.

For those executing Roth Conversion Ladders, a large amount on Line 4b is the equivalent of Homer Simpson’s Everything OK Alarm. Roth Conversion Ladders are intended to create a significant amount of taxable income, and Line 4b is where that income is reported on Form 1040. Note further that all Roth IRA conversions require the completion of Part II of the Form 8606.

Schedule A Line 17 Total Deductions

Those who claimed itemized deductions in 2020 should review Line 17 of Schedule A. Is the number reported for the total itemized deductions close to the standard deduction amount (for 2021, single taxpayers have a standard deduction of $12,550 and married filing joint taxpayers have a standard deduction of $25,100)?

If so, there a tax planning opportunity. Why is that number what it is? Is it because of charitable contributions? If so, the donor advised fund might be a good opportunity. Here’s how it might work:

Example: Joe and Lisa file married filing joint. In 2020, they itemized based on $10K of state taxes, $9K of mortgage interest, and $6K of charitable contributions ($500 a month to their church). Thus, at $25,000 of itemized deductions, they were barely over the threshold to itemize. In 2021, they move a sizable amount into a donor advised fund ($25,000). They use the donor advised fund to fund their 2021, 2022, 2023, and 2024 monthly church donations.

From a tax perspective, Joe and Lisa itemize in 2021 (claiming total deductions of $44K – the state taxes, mortgage interest, and a $25K upfront deduction for contribution to the donor advised fund). In 2022, 2023, and 2024, they would claim the standard deduction, which is (roughly speaking) almost equivalent to their 2020 itemized deductions.

By using the donor advised fund, Joe and Lisa get essentially the same deduction in 2022 through 2024 that they would have received without the donor advised fund, and they get a tremendous one year increase in tax deductions in 2021.

Form 8995 or Form 8995-A Line 2

Those with any amount on Line 2 of the Form 8995 or the Form 8995-A should likely consider some tax planning. This line indicates that the taxpayer has qualified trade or business income that may qualify for the new Section 199A qualified business income deduction. Taxpayers in this situation might want to consider consulting with a professional, as there are several planning opportunities available to potentially increase any otherwise limited Section 199A qualified business income deduction.

2021 Adjusted Gross Income Planning to Maximize Stimulus Payments

Taxpayers should review line 11 (adjusted gross income or “AGI”) on their Form 1040 in concert with reviewing their stimulus checks. For those taxpayers who did not receive their maximum potential stimulus payments in 2021, there can be opportunities to lower AGI so as to qualify for additional stimulus payments and/or increased child tax credits. I blogged about one planning opportunity in that regard here.

The Shift to Tax Planning

Tax planning can take many shapes and sizes. But it needs to be driven by goals, not by tactics. Bad tax planning begins something like this: “I need a Solo 401(k), how do I set it up?” N.B. Opening a Solo 401(k) when you do not qualify for one is a great way to create a tax problem for yourself.

Good tax planning begins more like this: “I want to achieve financial independence. How do I best save for retirement in a tax advantaged way? I’ve heard a Solo 401(k) is a great option. As part of this process, we should consider it as a possible way to help me achieve my goal.”

Another point: I find there is far too much focus on “I had to pay [insert perceived sizable amount here] this year in taxes” and far too little focus on lifetime taxes. To my mind, the goal should not be to pay less tax in any one year. Rather, the goal should be to legitimately reduce lifetime tax burden. Sure, there can be tax planning that does both, but the best tax planning (whether DIY or with the help of a professional) places reducing lifetime tax burden as its primary goal.

Below are just some areas where taxpayers can begin their tax planning considerations.

Retirement Planning

This is a big one. Taxpayers should understand whether they contribute to a traditional IRA and/or Roth IRA, and why or why not. This post helps explain whether taxpayers qualify to make an annual contribution to a traditional IRA and/or a Roth IRA.

Taxpayers should consider their workplace retirement plans, which can provide several planning opportunities.

Small Business/Self-Employment Income

For those with a small business and/or significant self-employment income, tax planning is very important. I have written several posts about just some of the tax planning available to those with small businesses. People with small businesses often benefit from professional, holistic tax and financial planning.

Stock Options

Stock options and employer stock grants provide some good tax planning opportunities. I’ve previously written about ISOs, but all kinds of stock option programs can be an opportunity to do some tax planning, which often should be with a professional advisor.

Conclusion

Filing timely, accurate tax returns is important. But the best way to optimize one’s tax situation is to do quality, intentional tax planning. Tax planning should prioritize goals over tactics. There is some tax planning that can be done by yourself, but many areas of tax planning strongly benefit from professional assistance.

FI Tax Guy can be your financial advisor! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

Understanding Your Form 1099-DIV

If you’re reading this in the Winter of 2024, you may have already received a bill from your financial institution. It’s called a Form 1099-DIV. Oddly, the financial institution isn’t demanding a penny of payment. Rather, your 1099-DIV prompts the IRS and your state tax agency (in most states) to expect the payment of income tax with respect to your financial assets.

A Form 1099-DIV is a great window into your taxable investments. By learning how to read the major boxes of your 1099-DIV, you can gain valuable insights about your investments and their tax efficiency.

VTSAX Form 1099-DIV 2024 Update

The Basics

Form 1099-DIV exists so that taxpayers and the IRS know the income generated by financial assets in dividend paying accounts. These include stocks, mutual funds, and exchange traded funds (“ETFs”). The financial institution prepares the Form 1099-DIV and submits a copy to the IRS and a copy to the taxpayer.

Let’s be clear about what we are talking about. We are not talking about assets in retirement accounts (401(k)s, IRAs, Roth accounts, HSAs, etc.). You do not receive a Form 1099-DIV from a retirement regardless of how much money the account earned during the year. This is one of the advantages of saving through a retirement account. Dividends and other income generated by assets in a retirement account are not taxable to the account holder when generated (so long as the funds stay in the retirement account).

Dividends

Corporations pay dividends to their shareholders as a return to the shareholders of their portion of some or all of the earnings of the corporation. The corporation’s Board of Directors vote from time to time to pay dividends to the shareholders. Boards determine dividends based on a variety of factors, including the company’s profitability, industry, stage in the corporate life cycle, and business cash needs.

All shareholders of a corporation receive dividends. Some of those shareholders are themselves mutual funds or ETFs. Mutual funds and ETFs distribute out dividends and certain other income they receive (such as interest) to their shareholders as dividends.

Box 1a and Box 1b

Box 1a lists the so-called “total ordinary dividends” received from the account. That is all of the dividends paid by the stocks, mutual funds, and ETFs in the account.

Box 1a should be understood as the entire pie. It represents all of the dividends received in the taxable account. The amounts in Box 1a are reported on line 3b of the Form 1040 (and on Schedule B if required).

Box 1b qualified dividends should be understood as a slice of the pie. It represents the portion of the total ordinary dividends that qualify for the long-term capital gains rates. Dividends create “ordinary income” for U.S. federal income tax purposes. However, certain “qualified dividends” (referred to as “QDI”) are taxed at preferential long term capital gains rates. As I have previously written, “[g]enerally, two requirements apply for the dividend to qualify for favorable QDI tax treatment. Very generally stated, they are:

The shareholder must own the stock for 60 of the 121 days around the “ex-dividend” date (the first date on which the stock sells without the right to receive the upcoming dividend); and,
The paying corporation must be incorporated either in the United States or in a foreign country with which the United States has a comprehensive income tax treaty.

Shareholders can obtain QDI treatment for stock owned through mutual funds and ETFs.

It may be that your qualified dividend slice is the entire pie. In most cases, there are usually some dividends that do not qualify for QDI treatment.

Amounts reported in Box 1b are reported on line 3a of the Form 1040.

Box 2a Capital Gain Distributions

Box 2a is the danger zone of the Form 1099-DIV. In a way, it is unavoidable to recognize dividends (even if such dividends are QDI) if one wants to invest in a broad based portfolio of equities in a taxable account. Eventually corporations pay out dividends. While younger companies tend not to pay dividends, as companies mature they tend to start paying dividends.

What are much more avoidable (at least to a degree) are capital gain distributions. Capital gain distributions come from mutual funds and ETFs (they do not come from individual stocks).

Capital gain distributions occur when fund managers sell individual holdings at a gain. The fund is required to (usually toward year end) pay out those gains to the shareholders. The paid out gains are reported in Box 2a.

Three things tend to increase capital gain distributions: 1) active management; 2) a bull market; and 3) fund redemptions.

Active Management

Usually, this is the most significant factor in capital gain distributions. In order to actively manage a mutual fund or ETF, fund managers generally need to buy and sell different holdings. The selling of holdings is what creates capital gain distributions.

Frequent trading can make certain actively managed mutual funds and ETFs very tax inefficient, because they trigger capital gain distributions that are currently taxed to the owner at capital gains rates.

From this, we can deduce the secret tax advantage of index funds. Index mutual funds and ETFs seek to simply replicate a widely known index. Other than occasional mergers and acquisitions of companies in the index, index fund managers rarely need to sell a holding to meet an investment objective. Thus, in many cases holding index funds in taxable accounts is tax efficient and will be better from a tax perspective than holding an actively managed fund.

Bull Market

Mutual funds and ETFs pass out capital gain distributions, not capital loss distributions. But in order for the shareholders to have a capital gain distribution, the mutual fund or ETF must (a) sell a holding and (b) must realize a gain on that sale.

In bear markets, it is often the case that the second requirement is not satisfied. The fund often realizes a loss on the sale of holding, meaning that the portfolio turnover does not generate a capital gain distribution reported in Box 2a. However, bear markets don’t always mean there will be no capital gain distributions, as active management and fund redemptions can still trigger capital gain distributions.

Fund Redemptions

There is an important distinction between mutual funds and ETFs in this regard. ETFs trade like public company stock — other than IPOs and secondary offerings, generally you buy and sell the stock of a public company and an ETF with an unrelated party that is not the issuer itself.

Mutual funds, on the other hand, are bought and sold from the issuer. If I own 100 shares of the XYZ mutual fund issued by Acme Financial, when I redeem my 100 shares, Acme Financial buys out my 100 shares.

In order to buy out mutual fund shares, the mutual fund must have cash on hand. If it runs out of cash from incoming investments into the fund, it will have to sell some of its underlying holdings to generate the cash to fund shareholder redemptions. This creates capital gain distributions for the remaining shareholders.

Interestingly, Vanguard has created a method to reduce the tax impact of mutual fund redemptions. Further, in recent times, fund redemptions have not caused significant capital gain distributions in many cases because in this current bull market mutual fund inflows often exceed outflows.

Box 3 Nondividend Distributions

There are occasions where corporations make distributions to shareholders during a time where the corporation does not have retained earnings (i.e., it either has not made net income or it has previously distributed out is net income). Such distributions are not taxable as dividends. Rather, such dividends first reduce the shareholder’s basis in their stock holding. Once the basis has been exhausted, the distribution causes a capital gain.

Box 5 Section 199A Dividends

Section 199A dividends are dividends from domestic real estate investment trusts (“REITs”) and mutual funds that own domestic REITs. These dividends are reported on Form 8995 or Form 8995-A and qualify for the Section 199A QBI deduction. The good news is that the taxpayer (generally) gets a federal income tax deduction equal to 20 percent of the amount in Box 5. This deduction does not reduce adjusted gross income but does reduce taxable income.

Section 199A dividends are another slice of the pie of Box 1a ordinary dividends.

Watch me explain Section 199A dividends

Box 7 Foreign Tax Paid

An amount in Box 7 is generally good news from a federal income tax perspective. Many countries impose a tax on the shareholder when the corporation pays a dividend is a non-resident shareholder. The corporation withholds a percentage of the dividend and then remits the net amount of the dividend to the shareholder.

The amount in Box 7 usually creates a foreign tax credit that reduces federal income tax dollar for dollar. If you have $300 or less in foreign tax credits ($600 or less if married filing joint) you can simply claim the foreign tax credit on your Form 1040 without any additional work. If your foreign tax credits exceed these amounts, you will also need to file a Form 1116 to claim the foreign tax credit.

The ability to claim foreign tax credits is a reason to hold international equities in taxable accounts.

Watch me discuss how VTIAX might generate a foreign tax credit on a US income tax return.

Boxes 11 and 12 Exempt-Interest Dividends and Private Activity Bond Interest

Box 11 represents all of the tax-exempt dividends received in the taxable account. Typically this is generated by state and municipal bond interest received by the mutual fund or ETF and passed out to the shareholders. This income is tax-exempt for federal income tax purposes.

This income may not be tax-exempt for state tax purposes. For example, in my home state of California, this income is taxable unless it is established that 50 percent or more of the funds assets are invested in California state and municipal bonds. In that case, the exempt-interest dividend attributable to California state and municipal bonds is tax-exempt for California purposes. The financial institution must separately provide the percentage of income attributable to California bonds to the shareholder in order to compute the amount of exempt-interest dividend exempt from California income tax.

Box 12 is a subset of Box 11 (Box 11 is the whole pie, Box 12 is a slice). Box 12 dividends are those attributable to private activity bonds. The significance is for alternative minimum tax (“AMT”) purposes. While this income is tax-exempt for regular federal income tax purposes, it is not tax-exempt for AMT purposes (and thus is subject to the AMT). After the December 2017 tax reform bill this issue still exists, though it affects far fewer taxpayers.

Conclusion

The Form 1099-DIV conveys important information, all of which must be properly assessed in order to correctly prepare your tax return. It can also provide valuable insights into the tax-efficiency of your investments.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter: @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.