Tag Archives: Qualified Dividend Income

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. 

Time to Stop 401(k) Contributions?

Ed Slott believes most Americans should not contribute to traditional 401(k)s. His recent essay on the subject is a great opportunity for the FI community to reassess its love for the traditional 401(k).

My conclusion is that for many in the FI community, traditional deductible 401(k) contributions are still the most logical path when it comes to workplace retirement saving. Below I explain my thinking. 

It is important to note it is impossible to make a blanket statement as applied to the entire FI community. 

Why the Traditional 401(k) Is Good for the FI Community

Many in the FI community have the very reasonable hope that in retirement they will have years, possibly decades, where their effective tax rate will be lower than their marginal tax rate in their working years. 

The above is true of many Americans, but it is particularly true if one retires early by conventional standards. The idea is deduct, deduct, deduct into the 401(k) during one’s working years (particularly the high earning years) and then retire early by conventional standards. Prior to collecting Social Security and/or required minimum distributions (“RMDs”), most retirees look artificially poor on their tax return. This opens up the door to affirmatively convert money from traditional retirement accounts to Roth accounts and pay tax at the lowest federal income tax brackets (currently 10% and 12%). For those who deducted contributions into the 401(k) at a 24% or greater marginal federal tax rate, this is great tax rate arbitrage planning.

Minor litigation risks aside, this strategy just got even easier for those born in 1960 and later, who don’t have to take RMDs under SECURE 2.0 until age 75. With the new delayed RMD beginning date, even those retiring as late as age 65 will have a full decade prior to being required to take RMDs to do tax-efficient Roth conversions at low marginal tax rates. For some in the FI community, this opportunity window might not be a decade long but rather a quarter-century long (if they retire at age 50). 

How Bad is the Retiree Tax Problem?

As wonderful as FI tax rate arbitrate planning might be, Ed Slott’s concern that retiree taxes will increase is not entirely unwarranted. It is obvious that the government is not fiscally responsible, and it is obvious that tax increases could be coming in the future. 

Let’s assess the situation by looking at just how bad the problem of taxes is in retirement.

We begin with a baseline case. David and Hannah are in their 70s. They never did Roth conversions in early retirement and have the bulk of their financial assets in traditional IRAs and traditional 401(k)s. During most of their working years, David and Hannah maxed out 401(k)s and got deductions in the 24% bracket or greater. For 2023, they have taxable RMDs of $160,000, Social Security of $40,000, $4,000 of qualified dividends and $1,000 of interest income. How bad is their federal income tax situation?

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (27,700)
Additional SD Age 65+$ (3,000)
Federal Taxable Income$ 168,300
Federal Income Tax (Estimated)$ 27,361
Effective Tax Rate on AGI13.75%
Marginal Federal Income Tax Rate22%

Under today’s rules, David and Hannah, who did no tax planning other than “deduct, deduct, deduct” are doing great. Their federal effective tax rate, even with $200K of RMDs and Social Security, is just 13.75%. They incur such a low effective tax rate because their RMDs go against the 10% tax bracket, the 12% bracket, and the 22% bracket. 

While I do think David and Hannah would be in a better position had they done some tax efficient Roth conversion planning earlier in retirement, their unbridled enthusiasm for traditional retirement accounts served them well. 

Note: David and Hannah are borderline IRMAA candidates: a $199K 2023 AGI might cost them approximately $2,000 in IRMAA surcharges in 2025 (but it is possible that inflation adjustments for 2025 will prevent that from happening). This is another reason to consider pre-RMD Roth conversions at lower marginal tax rates. 

Update 8/19/2023: But what about the widow’s tax trap? If David or Hannah die, won’t the survivor get crushed by tax increases? Check out this estimate. Assuming the survivor loses the lower-earning spouse’s Social Security benefits of at least $10,000, the survivor’s marginal federal income tax rate would climb from 22% all the way up to . . . 24%!

But what about future tax increases? Okay, let’s add four tax increases to the picture and see just how bad it looks:

  1. Eliminate the TCJA increase to the standard deduction (the law reverts to pre-2018 lower standard deduction and personal exemptions). This would reduce David and Hannah’s deductions by roughly $2,740, costing them approximately $602.80 in additional federal income tax (at today’s 22% marginal tax rate).
  2. Eliminate the TCJA decrease in the 15% tax bracket to 12%. This would cost David and Hannah $2,023.50 in additional federal income tax. I’m highly skeptical that either of these two tax increases will actually occur, but as written in today’s laws they are scheduled to happen in 2026. 
  3. Increase the 15% long term capital gains and qualified dividend income rate to 25%. While I believe that the real risk is an increase in the 20% long term capital gains and qualified dividend income rate, let’s stress test things and consider a large increase in the 15% rate. In David and Hannah’s case, this costs them $400 in additional federal income tax.
  4. Increase the 22% tax rate to 33%. Ed Slott is worried about large tax rate increases, so let’s consider one that I believe is politically infeasible, a 50% increase in the 22% tax bracket. This type of tax rate increase would hit millions of voters in a major way. But it’s helpful to consider what could be a worst case scenario. In this case, this tax rate increase costs David and Hannah an additional $8,233.50 in federal income tax.
  5. There’s one more tax hike to consider: the combination of tax increases numbers 1 and 4. If both occurred together, combined they would cost David and Hannah an additional $301.40 in federal income tax. 

Here’s what David and Hannah’s federal tax picture looks like if all of the above tax increases occur:

Federal Income Tax Return
RMDs$ 160,000
Social Security$ 40,000
15% Social Security Exclusion$ (6,000)
Interest$ 1,000
Qualified Dividends$ 4,000
Adjusted Gross Income (“AGI”)$ 199,000
Standard Deduction$ (15,240)
Additional SD Age 65+$ (3,000)
Personal Exemptions$ (9,720)
Federal Taxable Income$ 171,040
Federal Income Tax (Estimated)$ 38,922
Effective Tax Rate on AGI19.56%
Marginal Federal Income Tax Rate33%

Significant tax increases hurt David and Hannah, but how much? By my math, very significant tax increases, including a 50% increase in the 22% bracket, cost them about 6% of their income. Not nothing, but wow, they’re still doing very well. 

Yes, on the margin, the last dollars David and Hannah contributed to the traditional 401(k) were not ideal since they faced a 33% marginal federal tax rate in retirement. But let’s remember (i) their overall effective rate is still more than 4 percentage points lower than their working years’ marginal rate (at which they deducted their 401(k) contributions), (ii) they have income significantly above what most Americans will have in their 70s, and (iii) in my scenario they face four separate tax hikes and still pay a federal effective tax rate less than 20 percent.

Future Retirees’ Tax Risk

Do future tax hikes pose no threat to future retirees? Absolutely not! But my stress test shows that many Americans with substantial RMDs will not get walloped even if Congress enacts unpopular tax increases. Considering many in the FI community will have modest RMDs due to pre-RMD Roth conversions, the threat of future tax hikes is even less perilous for the FI community.

Further, many Americans, particularly those in the FI community, have a great tool that can mitigate this risk: Roth conversions during retirement! With RMDs now delayed to age 75 for those born in 1960 and later, many Americans will have years if not decades where money can be moved in a tax-efficient manner from old traditional accounts to Roth accounts. 

Further, many Americans can claim deductions at work and then at home contribute to a regular Roth IRA or a Backdoor Roth IRA. This too mitigates the risk of having all of one’s retirement eggs in the traditional basket. 

Last, do we really believe that Congress is just itching to raise taxes on future retirees? Sure, it’s possible. But to my mind taxes are more likely to be raised on (i) those in higher ordinary income tax brackets and/or (ii) long term capital gains and/or qualified dividends (particularly the current 20% bracket). If anything, the most Congress is likely to do to retirees is slightly increase their taxes so as to mitigate the political risk involved in raising taxes on retirees who tend to vote. 

The Risks of Not Having Money in Traditional Retirement Accounts

Risk isn’t a one-way street. There are some risks to not having money in traditional retirement accounts. I identify three below.

Qualification for Premium Tax Credits

Picture it: Joe, age 55, retires with the following assets: (i) a paid off car, (ii) a paid off house, (iii) a $40,000 emergency fund in an on-line savings account, and (iv), $2 million in Roth 401(k)s and Roth IRAs. He heard that Roth is the best, so he only ever contributed to Roth IRAs and Roth 401(k)s, including having all employer contributions directed to a Roth 401(k). Having fallen into the Rothification Trap, in retirement Joe must work in order to generate sufficient taxable income to qualify for any ACA Premium Tax Credit. 

For at least some early retirees, the ability to create modified adjusted gross income by doing Roth conversions will be the way they guarantee qualifying for significant Premium Tax Credits to offset ACA medical insurance premiums. 

Charitable Contributions

Many Americans are at least somewhat charitably inclined. Starting at age 70 ½, Americans can transfer money directly from a traditional IRA to a charity, exclude the distribution from taxable income, and still claim the standard deduction. Essentially, if you’re charitably inclined, at a minimum you would want to go into age 70 ½ with enough in your traditional IRAs (likely through contributions to traditional 401(k)s that are later transferred to an IRA) to fund your charitable contributions from 70 ½ until death. 

Why ever pay tax on that money (i.e., by making contributions to a Roth 401(k) that are later withdrawn to be donated) if the money is ultimately going to charity anyway?

Unused Standard Deductions

Currently, the government tells married couples, hey, you get to make $27,700 a year income tax free! Why not take advantage of that exclusion every year, especially prior to collecting Social Security (which, in many cases will eat up most, if not all, of the standard deduction). 

Why be retired at age 55 with only Roth accounts? By having at least some money in traditional retirement accounts going into retirement, you ensure you can turn traditional money into Roth money tax-free simply by converting (at any time) or even distributing (usually after age 59 1/2) the traditional retirement account against the standard deduction. 

Deduct at Work, Roth at Home

I think for many it makes sense to max out traditional 401(k)s at work and contribute to Roth IRAs or Backdoor Roth IRAs at home. Why? As discussed above, traditional 401(k)s can set up tax rate arbitrage in retirement, help early retirees qualify for Premium Tax Credits, and make charitable giving after age 70 ½ very tax efficient. At home, many working Americans do not qualify to deduct IRA contributions, so why not contribute to a Roth IRA or Backdoor Roth IRA, since (i) you aren’t giving up a tax deduction in order to do so and (ii) you establish assets growing tax free for the future. 

In this post I discuss why deduct at work, Roth at home can often make sense and I provide examples where Roth 401(k) contributions are likely to be better than traditional 401(k) contributions. 

Conclusion

I believe that for many in the FI community, a retirement savings plan that combines (i) traditional deductible 401(k) contributions during one’s working years and (ii) Roth conversions prior to collecting RMDs is likely to be a better path than simply making all workplace retirement contributions Roth contributions.

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

Follow me on Twitter at @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.

A Critical Look at the 529

Thanks to the SECURE 2.0 bill, it’s time for the FI community to reexamine 529 plans. This post shares my two cents on 529s in general, and specifically as applied to the FI community. The next post, dropping February 15, 2023, addresses in detail the new 529-to-Roth IRA rollover enacted in SECURE 2.0.

Financial Independence

Before we talk about 529s, we have to talk about the primary goal of financial independence. For young parents, the primary goal is to secure Mom & Dad’s financial independence. 

Achieving the parents’ primary goal has an incredible secondary effect. Mom and Dad buy Junior an incredible gift by securing their own financial independence. That gift is that Junior will never have to worry about Mom and Dad’s financial security as an adult. The greatest financial gift parents can ever give their children is the parents’ own financial stability. 

Second, where possible, money and financial assets should be able to support multiple financial goals. We should be at least somewhat hesitant before locking up money such that it can only support one highly specific goal without incurring a penalty. 

529s

529s are tax-advantaged savings accounts generally run by states to facilitate college savings. 529s are best understood as a Roth IRA for college education with far greater contribution limits. Sure, that is an overstatement of how they work, but that gives us a good conceptual framework from which to start the analysis. 

A quick note on terminology: The IRS often refers to 529 plans as “Qualified Tuition Programs” or “QTPs.” I will use the more commonly used colloquialisms, 529 and 529s. 

Contributions to a 529 are not tax deductible for federal income tax purposes. At least initially, there’s no federal income tax benefit to making a 529 contribution. However, money inside a 529 grows federal and state tax-free and can be withdrawn tax-free for qualified education expenses (such as college tuition). 

Contributions are generally not limited by federal tax law, though contributions above the annual exclusion gift tax limit ($17,000 per donor per beneficiary per year in 2023) generally trigger Form 709 reporting requirements (though in 99.99% of cases there should not be a gift tax liability). States generally have lifetime contribution limits per beneficiary. Usually these limits are far in excess of what one would normally need for undergraduate college tuition. 

Very generally speaking, qualified education expenses can be directly paid from the 529 to the educational institution or such expenses can be reimbursed from a 529 in the year the expenses are incurred. Payments for qualified educational expenses are generally tax and penalty free. 529s do not enjoy the rather unlimited reimbursement deadline that HSAs enjoy. 

529s get similar tax treatment to the federal income tax treatment in most states. However, there can be an additional benefit: an annual state tax deduction or credit for some 529 contributions to the state’s own 529 plan (note 8 states allow a 529 tax deduction or credit for contributions to other states’ 529 plans). However, for many readers this will either be irrelevant or only of minor importance. Of the four most populous states (CA, TX, FL, NY), only residents of New York can obtain an up-to $5,000 per person per year state tax deduction for contributions to a home-state 529. California has no 529 tax deduction and Texas and Florida do not have an income tax.  

Okay, sounds great! Clearly there are tax benefits for 529 money used for qualified education expenses. But what about distributions that are used for anything other than qualified education expenses? Well, they are going to be subject to an income tax and likely a 10 percent penalty, in the following manner. A non-qualified distribution is deemed to come ratably out of the contributions to the 529 (tax and penalty free) and earnings of the 529 (subject to income tax and the 10 percent penalty, some penalty exceptions may apply). 

Here’s an example illustrating the application of the nonqualified distribution rules:

Hal, the owner of a 529 account, takes $1,000 out of the 529 to help pay for vacation expenses. Previously, he had made $60,000 of contributions to the 529, and it had grown to $100,000 ($40,000 of earnings) prior to making the $1,000 non qualified distribution. Sixty percent of the distribution ($600) is a nontaxable return of contributions and 40 percent ($400) is subject to both income tax and a 10 percent penalty.

The taxation of non-qualified distributions is a significant drawback of using 529s. 

529s and the FI Community

Let’s remember what is going on with a 529. It is a gift to the next generation. It comes with very modest tax benefits. 

My thesis on the 529 is this: for most parents, including most of those in the FI community, the tax benefits offered by 529s are not sufficient to compensate for the use restrictions on 529s. Thus, my view is that 529s should generally be deployed once Mom and Dad are financially independent (or close to it), not when they are on the path to financial independence. 

The idea behind the 529 is to provide tax-free growth for college savings. It solves for something that, frankly, isn’t much of a problem. Taxes are not why college is unaffordable for many Americans. College tends to be unaffordable not because investment taxes are high, but because tuition and fees are out of control. 

One thing in parents’ favor when thinking about funding college educations is that income taxes on investments are relatively modest over a child’s childhood due to low long term capital gains rates and qualified dividend income rates. Hopefully, by age 22 or 23, the child’s undergraduate education is completed, providing a relatively modest investment time horizon (i.e., a modest tax exposure horizon), even if the parents start saving for college at birth. 

Contrast that to the retirement time horizon of a 20-, 30- or 40-something parent saving for his or her own retirement. The money invested for retirement at age 25 might be accessed at age 60, 70, 80, or 90. Compared to educational savings, retirement savings (which are usually far greater than educational savings) are much more vulnerable to income taxes for a much longer time frame. Even at long term capital gains and qualified dividend income rates, exposing retirement savings to decades of taxation could be very expensive. Retirement savings are also exposed to tax law change risk for a much longer period of time. For example, there’s no guarantee that there will be favored long term capital gains and qualified dividend tax rates 30 years from now.

The tax risk profiles on educational savings and retirement savings are much different. Based on those risk profiles, for most I believe aggressive retirement tax planning makes sense. But I don’t see educational tax planning making as much sense, for the reasons discussed below. 

Of course, tax-advantaged retirement savings can come with a juicy up-front federal income tax deduction. 529s do not offer the possibility of a federal income tax deduction, making them less impactful than tax-advantaged retirement savings regardless of the time frame involved. 

Young Parents and 529s

Let’s consider young parents. Say Junior is born when Mom & Dad are age 30 and have saved 10 times their annual expenses in financial assets. Many, myself included, would say Mom and Dad are doing well with their finances. Here’s where I diverge from some others in the personal finance space: I would not recommend Mom & Dad save in a 529 shortly after Junior’s birth.

Notice I’m not saying Mom & Dad should not pay for Junior’s college. What I’m saying is Mom and Dad should stay flexible for their own financial future. 

What’s so horrible about Mom & Dad starting to save for Junior’s college in a taxable brokerage account under their own names? At birth, they have no idea if Junior will get a scholarship, go to trade school, how Mom & Dad’s finances will be when Junior is ready to go to college, etc. By saving in financial assets that are in their own names–perhaps mentally segregated as potentially being for Junior’s college–Mom & Dad maintain great flexibility without sacrificing too much tax benefit. 

If Junior gets a scholarship, great, the financial assets stay with Mom & Dad. If Mom & Dad are not financially successful when Junior goes to college, great, the financial assets can support Mom & Dad and Junior can figure out other ways to pay for college. 

The Value of the 529’s Tax Benefits

How bad is the tax hit on holding investments for a child’s college education? Imagine owning a 60 / 40 equity to bond portfolio of $100,000 for a child’s college education. If held in the parents’ taxable brokerage account, how much taxable income might that generate annually? Very roughly, if dividend yields are 2 percent, the $60,000 in equities would produce $1,200 of dividend income, most of which is likely to qualify for qualified dividend income tax rates. The $40,000 of bonds would produce $1,800 of ordinary income at a 4.5 percent yield. 

Is it desirable to add $3,000 of income to Mom and Dad’s tax return? Surely not. Cataclysmic? Also surely not. 

Consider what a small amount of additional taxable income buys. If the money is held in the parents’ names, it can be used for anything without penalty. Perhaps Mom and Dad have not been financially successful. That $100,000 could help the parents achieve their own financial goals and retirement. What if the child gets a scholarship and does not need much in the way of tuition assistance from his or her parents? What if the child doesn’t go to college? 

In exchange for paying tax on $3,000 of income annually (some of it at tax-favored QDI rates), and some long term capital gains when used to pay tuition, Mom and Dad have incredible flexibility with the $100,000. Maybe $50,000 goes for Junior’s college tuition, and $50,000 goes for Mom and Dad’s retirement. Further, for many it won’t be $3,000 of income annually. It will take most parents years before they could accumulate the sort of balance that would generate $3,000 of taxable income from educational savings. Thus, the tax hit for not using the 529 is likely to be that much less in the years well before the child is close to college age. 

Outside of the handcuffs of the 529, assets can support multiple financial goals. Even better, as one financial goal is met, the money can be shifted to support another financial goal. Perhaps Mom and Dad are behind in their own savings when Junior is age 10. But things go well, and when Junior turns 16 Mom and Dad have wealth in excess of their FI number. In that case, money that might have been needed for the parents’ retirement now can be used for college tuition.

Use Restrictions

We need to consider the use restrictions on 529s. If not used for qualified education expenses, the growth is subject to both ordinary income tax and usually the 10 percent penalty.

Compare the tight use restrictions on 529s to the use restrictions on the other most prevalent tax baskets: taxable accounts, traditional retirement accounts, Roth accounts, and health savings accounts. Generally speaking, all of them (even HSAs) are not use-restricted or only partially use-restricted. All four of those tax baskets have a significant advantage over 529s in terms of use restrictions.

In many cases, I believe that the 529’s significant use restrictions are not adequately compensated by its tax advantages. 

The 529 has rather onerous time restrictions, as distributions of earnings are generally subject to tax and the 10 percent penalty in those years there are no qualified education expenses.

Feeding the Beast

As much as we might want to, we can’t turn a blind eye towards hyperinflation in college tuition. With that in mind, shouldn’t we ask: Isn’t a hyperfocus on college savings feeding the beast? 

It’s time to scrutinize American higher education. It’s not good for the country to have students graduating with mountains of debt. This is happening for many reasons, including significant administrative bloat in higher education. Clearly, American higher education is failing too many of its students. Is now the time to set aside money to pay American colleges and universities?

I get it: no one reader funding a 529 is the cause of the problems of American higher education. 

But, if I’m a university used to collecting soaring tuition and fees, I’m all for 529s. 529s subsidize what has become bad behavior by university administrators. Less focus on 529s helps move the needle towards universities needing to act responsibly in order to attract students. 

Camilla Jeffs raises an interesting point on her LinkedIn page: Part of the reason college is so expensive is because in many cases the customer (the student) does not bear the cost. 529s feed into that problem. Camilla’s recent podcast episode on 529s is also full of good food for thought. 

529 Use Cases

The above limitations of the 529 noted, I do believe there are good use cases for the 529. These cases assume that the parents have decided to pay for their child’s college education.

Financially Independent Parents

Joe and Sally are married and 45 years old. They have saved 30 times their annual expenses in retirement accounts and taxable brokerage accounts. They have a 10 year old daughter they are reasonably sure will go to college, and they would like to pay for her college education.

This is a great use case for the 529. Mom and Dad’s financial future largely secured (generally speaking), it’s time to focus on (i) college savings, since they want to pay for college, and (ii) tax planning. Joe and Sally, already holding substantial taxable brokerage accounts, benefit from saving through the 529 so they avoid adding more dividend, interest, and capital gains income to their annual tax return. 

Capturing State Tax Benefits

Aaron and Amanda are married and are 50 years old. They have saved 20 times their annual expenses in retirement accounts and taxable brokerage accounts. They have stable jobs. They have a 16 year old son who is very likely to go to college. Aaron and Amanda want to pay for their son’s college education. Since they live in New York State, if they contribute $10,000 annually to the New York 529 for his benefit ($5K each), they get an annual $10,000 state tax deduction on their New York state income tax return.

Aaron and Amanda are not financially independent by many metrics, but they are doing pretty well, and are likely (though not guaranteed) to be financially successful. In their case, paying for college is not financially ruinous. If Aaron and Amanda are going to pay for college, they might as well utilize the 529 annually to scoop up state tax deductions, particularly in a higher income tax state like New York. Further, beginning the 529 much closer to the start of college decreases the odds that the 529 will become over funded.  

Contrast Aaron and Amanda to parents of newborns. Newborns’ parents are closer to the beginning of their financial journey. In most such cases, state tax benefits would not, in my opinion, be valuable enough to justify the use restrictions on 529 contributions. 

Conclusion

My view is that the detriments of the use restrictions on 529s are not adequately compensated by the federal and state tax advantages offered by 529s in most cases. That’s certainly not to say there are not good use cases for the 529, but my view is that most parents should prioritize saving in their own names (even in taxable accounts) before making contributions to 529 accounts. 

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.

The Special Tax Loss Harvesting Opportunity for 2022

There is a tax loss harvesting opportunity in 2022 that has not existed in recent years to the scope and scale it exists today: tax loss harvesting with bonds and bond funds. In most recent years, many bonds and bond funds have not had significant built-in-losses. 2022 is different: now there are plenty of bonds and bond funds in taxable accounts with significant built-in-losses. 

Tax Basketing for Bonds and Bond Funds

Bonds tend to be tax inefficient, for two reasons. First, they generate ordinary income, which is taxed at the taxpayer’s highest marginal tax rate. Second, they tend to have higher yields than equity investments. Thus, a dollar of a bond fund often produces more taxable income than a dollar of an equity fund, if they are both owned inside a taxable account.

As a result, holding bonds and bond funds in traditional retirement accounts is often logical from a tax basketing (or tax location) perspective. If they produce ordinary income anyways, why not hold them in a traditional retirement account (IRA, 401(k), etc.) where the owner can defer the timing of the ordinary income taxable event (through later Roth conversions and/or distributions)? 

Tax Basketing for Stocks and Equity Funds

Bonds also don’t suffer from the “transmutation” problem equities have. Stocks and equity funds, in most cases, pay “qualified dividend income” which qualifies for the lower long term capital gains tax rates (including the 0% long term capital gains tax rate). Holding them in a traditional retirement account transmutes that preferred income into ordinary income, subject to the taxpayer’s marginal ordinary tax rate. 

Now, as a practical matter, most Americans have most of their non-real estate financial wealth in traditional retirement accounts. Having some equities in traditional retirement accounts should not in any way cause despair. But, on the margins, it can be beneficial to review the overall portfolio to see if there can be some tax efficiency gains made by some tax rebasketing of assets. 

Rebasketing and Tax Loss Harvesting

The deadline for tax loss harvesting for 2022 is December 31, 2022. 

To my mind, some of the best 2022 tax loss harvesting will be selling bonds and bond funds at a loss in taxable accounts. Why is that? Because this sort of tax loss harvesting enjoys the main benefits of tax loss harvesting and it can achieve a great tax basketing result. 

Bonds create ordinary income and are generally higher yielding than equities, which often produce tax favored qualified dividend income. Thus, from a tax basketing or tax location perspective, it can often make sense to hold bonds and bond funds in a traditional retirement account and hold equities in a taxable account. Today, many investors can do some tax loss harvesting and strategically reconfigure their portfolios to make them much more tax efficient. Here is an example of how this could play out.

Jorge is 30 years old. He currently owns a diversified equity fund (Fund A) inside his workplace traditional 401(k) plan worth $80,000. It has a 2% annual dividend yield, most of which is qualified dividend income (though of course it is tax deferred inside the 401(k) and will later be subject to ordinary income tax when withdrawn or Roth converted). Separately, he owns a diversified bond fund (Fund B) inside his taxable brokerage account. It is worth $20,000, and Jorge has a $24,000 tax basis in the fund. The bond fund has a 3% annual interest yield ($600), all of which is ordinary income. Jorge wants to have an 80% / 20% equity to bond allocation. 

Here’s Jorge’s portfolio today:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$80,000None
Taxable Fund B (Bond)$20,000$600
Total$100,000$600

Jorge, could, in theory, execute two transactions to both tax loss harvest and become more tax efficient from a tax basketing perspective. First, Jorge could exchange his $20K of Fund B for $20K of an equity fund inside his brokerage account with a dividend yield similar to Fund A. Second, inside his 401(k), he could exchange $20K worth of his Fund A holding for a bond fund with an income yield similar to Fund B. If Jorge’s new fund inside the 401(k) is not substantially identical to Fund B, he can claim most, if not all, of the $4,000 loss, though the prior month’s Fund B dividend might slightly reduce the loss under the wash sale rule.

Here’s Jorge’s portfolio after these two transactions:

AssetAmountAnnual Taxable Income
401(k) Fund A (Equity)$60,000None
401(k) Bond Fund$20,000None
Taxable Equity Fund$20,000$400
Total$100,000$400

Jorge may obtain two tax benefits from these transactions. First, assuming he successfully navigates the wash sale rule, he may be able to deduct up to $3,000 against ordinary income by triggering the capital loss on the Fund B sale. 

Second, regardless of whether he successfully navigated the wash sale rule, he has just made his portfolio more tax efficient. It used to be that he reported $600 of ordinary income (from Fund B) on his tax return. Now that sort of interest income is hidden inside the 401(k). If he now receives approximately $400 a year in qualified dividend income from the new equity fund inside the taxable brokerage account, he has (i) reduced his annual taxable income by $200 (and growing through compounding) and (ii) now has mostly qualified dividend income from the taxable account instead of ordinary income, lowering his federal tax rate on his portfolio income. He has done all that without disturbing his overall asset allocation. 

Getting the tax basketing of his investments better without changing his investment allocation is likely to be worth it even if loses the tax loss due to the wash sale rule. He would want to review the options available to him inside his 401(k) to see if there is an acceptable (to him) bond fund that is not “substantially identical” to Fund B so as to avoid the wash sale rule being triggered by the investment in a bond fund inside the 401(k). 

Conclusion

Declines in the stock and bond market are some of the lemons of 2022. But, there’s a chance to make some lemonade. When it comes to bonds held in taxable accounts, there may be an opportunity to obtain two benefits: tax loss harvesting and better tax basketing. 

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

Follow me on Twitter 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, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

S Corporations for Beginning Solopreneurs

Last month the blog discussed the beginning of the self-employment journey. Specifically, it discussed how one pays taxes when they become self-employed. This post goes further. It explores a potentially powerful tax planning for self-employed solopreneurs, the S corporation. 

None of the below is tax advice for any particular taxpayer. Note that if you are considering an S corporation, you are generally well advised to work with a tax professional before and during the process of implementing an S corporation. 

The S Corporation Concept

Generally speaking, a corporation is subject to federal income tax at a 21 percent rate. For example, if Acme Incorporated has $100,000 of taxable income for the year, it owes the IRS $21,000 of federal income tax. Further, the shareholders are subject to taxes on the receipt of dividends from the corporation. If Acme Incorporated pays its after tax profit of $79,000 to its shareholders, generally its shareholders must include the receipt of the dividend in taxable income (though the dividend may qualify for the favorable qualified dividend income rates). 

Based on both the corporation and the shareholders having to pay tax on the same income, it is said that many corporations (so-called “C corporations”) are subject to double tax. 

For smaller businesses, this can be very problematic. The tax rules recognize this, and thus, for certain small business entities, allow an “S corporation” election (meaning that the corporation is taxed under the rules of Subchapter S of the Internal Revenue Code).

S corporations are generally subject to only one level of tax, as all of the tax items of the S corporation (taxable income, gain, loss, credits, etc.) are reported and taxed on the shareholder(s) individual tax returns. The S corporation itself usually does not pay federal income tax. 

Most states replicate this treatment to a large extent. For example, in my home state of California, S corporation income is reported on the shareholders’ tax returns, but the S corporation itself is subject to a 1.5% income tax (with a minimum annual tax due of $800 regardless of income). 

The Self-Employment Tax Savings and Reasonable Compensation

There is another wrinkle to S corporations which can make them advantageous to solopreneurs. The S corporation must pay owner-employees reasonable compensation as W-2 salary. However, the rules generally allow the owner-employee to take some of the earnings of the S corporation as a dividend. This has the rather interesting effect of, in many cases, reducing the overall payroll tax liability of the solopreneur. 

Here’s a quick example of how that could work:

Aurora works as a private detective. After business expenses, she has a net income of $110,000. The payroll taxes she pays will depend on whether the business is organized as a sole proprietorship or an S corporation. 

If she is operating as a sole proprietorship, she will pay $15,543 in self-employment taxes, as computed on Schedule SE (roughly, 14.13% of her profits are due in self-employment taxes). 

Things are different if the business is organized as an S corporation. Assume, just for the sake of this example, that the S corporation pays Aurora $55,000 in W-2 compensation and this is reasonable. The FICA tax she and the S corporation together pay is 15.3% of that amount, $8,415. 

In this example, Aurora saves over $7,000 in payroll taxes by electing to operate out of an S corporation.

Of course, compensation must be reasonable. S corporation owner-employees who pay themselves very small W-2 salaries can have dividend payments recharacterized as W-2 salary, prompting disputes with the IRS and state taxing agencies and the collection of back payroll taxes.

Solopreneur Requirements for an S Corporation

Below I discuss, very broadly, the general requirements to establish and maintain an S corporation for a solopreneur who does not employ other people. Those items with a single asterisk can (but does not have to) apply to a Schedule C sole proprietorship (for example, for solopreneurs a limited liability company can be either a Schedule C sole proprietorship or an S corporation). The item with a double asterisk also applies to a sole proprietorship, but perhaps to a somewhat lesser extent. 

Entity Formation*

To have an S corporation, one must operate out of a legal entity. Generally, the legal entity can be a corporation or a limited liability company (an “LLC”). Corporations and LLCs are creatures of state law. Each state has its own formation and regulation procedures, requirements, and fees. Often it is wise to consult with legal counsel when forming a legal entity.

Under the federal income tax rules, an S corporation generally must have 100 or fewer shareholders and only a single class of stock outstanding. 

Tax Election

Electing S corporation status requires the filing of a Form 2553 with the IRS with the signatures of all the shareholders. In community property states, usually one’s spouse is considered a shareholder. Taxpayers omitting a spouse’s signature where the S corporation stock is community property can fix the omission under the procedure available under Revenue Procedure 2004-35. 

Entity Maintenance*

Legal entities have requirements for maintenance. These vary by state, and can include annual fees, annual shareholders’ meetings, and meetings of a Board of Directors. Consultations with legal counsel can be helpful in this regard. 

Separate Books, Records, and Bank Accounts**

A legal entity should have its own bank account to collect revenue and pay expenses. Most solopreneurs operating out of either a sole proprietorship or an S corporation are well advised to hire a (very likely virtual) bookkeeper to track revenues and expenses. 

Separate Federal Income Tax Return

S corporations must file an annual income tax return with the federal government, the Form 1120-S. Included in this Form is a Form K-1. Form K-1 reports to both the shareholders and the IRS the ordinary income and other tax results of the S corporation for the year that must be reported on the income tax returns of the shareholders.

Generally speaking, the Form 1120-S is due March 15th, but can be extended to September 15th. 

Separate State Income Tax Return

In most states, S corporations have to file income tax returns. There can be entity level taxes on S corporations (such as California’s 1.5% income tax, $800 minimum tax) and in most states the shareholders will need to report the S corporation’s income on their own state income tax return. 

Running W-2 Payroll/Reasonable Compensation

S corporations must pay their employees, including solopreneur owners, reasonable compensation. This requires running W-2 payroll, including federal and state payroll tax withholding and remittance. There are payroll processors that specialize in providing payroll services for small S corporations. 

As discussed above, W-2 compensation must be reasonable. 

Forms W-2, W-3, 940, and 941

There are both quarterly and annual payroll tax returns that must be filed to report salaries paid and payroll taxes withheld and remitted. The Form 941 is filed for each quarter and is generally due one month after the end of the quarter. 

Forms W-2, W-3, and 940 are filed on an annual basis and generally due January 31st.

Tracking Distributions and S Corporation Stock Basis

Shareholders must track their “basis” in their S corporation stock. Generally speaking, dividends from an S corporation are not taxable to the shareholder. However, they reduce the shareholder’s basis in their S corporation stock. If the shareholder receives a distribution at a time he or she does not have basis in their S corporation stock, it triggers a taxable gain to the shareholder.

Basis should generally be tracked as part of the tax return preparation process. However, basis should also be tracked during the year prior to the shareholder taking significant dividends from the S corporation. 

Increased Professional Fees

Operating out of an S corporation generally increases the professional fees a solopreneur pays. This absolutely can be worth it, but in many cases there needs to be professional assistance regarding reasonable compensation, tax filings, legal maintenance, and payroll processing. 

Tax Planning

In a world without two of my favorite tax topics, the qualified business income deduction and the Solo 401(k), the analysis was usually somewhat straightforward. Estimate business income and run it through the filters of income and self-employment tax if reported on a Schedule C versus income and payroll tax if reported through an S corporation. This yielded an estimate of the overall tax savings obtained using an S corporation structure. 

To make the “S corporation or Schedule C” decision, the taxpayer would then, for the most part, compare the estimated annual tax savings versus the additional administrative burden and costs associated with the S corporation. 

Today, we live in a world with the qualified business income deduction and the Solo 401(k). These planning opportunities make the “S corporation or Schedule C” question more nuanced. At a minimum, solopreneurs should work with their tax advisors to model out what the income tax, self-employment tax, qualified business income deduction, and retirement plan results look like at their anticipated business income level and desired retirement plan contribution level to determine whether the S corporation or the Schedule C route is better. 

Operating through an LLC

One option available to solopreneurs is operating out of an LLC as the sole owner. LLCs provide a legal entity out of which to conduct business. Properly operated, an LLC can provide a solopreneur with liability protection and reputational advantages. One great feature of LLCs is their tax flexibility. They default to disregarded status, meaning that for a solopreneur, the default option is that the taxable income of the LLC is simply reported on their Schedule C. However, using the Form 2553, a solopreneur can elect to have the LLC treated as an S corporation.

Those looking to work through an LLC should consider hiring legal counsel regarding the establishment and maintenance of their legal entity. 

Conclusion

Operating out of an S corporation is a significant additional operational commitment. There are instances where it can make a great deal of sense for a solopreneur. Those considering using an S corporation should understand the administrative commitment involved and should work with advisors as appropriate to ensure they make an informed decision. 

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.