Hello, Mr. Taxman! It's refund time for many investors--but it'll take some work. Filing is more complicated than ever. Here's how to do it
(MONEY Magazine) – If you dread doing your taxes, there's good news and bad news.
First the good news: The 2003 tax cuts mean you're more likely to get a bigger refund, or at least pay less tax, come April. The $350 billion tax package lowered marginal income tax rates retroactive to Jan. 1, yet employers did not change withholding until July. So for the first half of the year, most of us had too much federal tax taken out of our paychecks. One of those cynical election-year ploys? Perhaps. But for the nation's 131 million individual taxpayers, it lessens the pain of tax time. For investors, of course, the tax package offered even more goodies, with reduced rates on long-term capital gains and qualified dividends.
Now the bad news: In the long run, the 2001 and 2003 tax cuts will push more and more of us into the alternative minimum tax (AMT), a second tax system meant for the ultrawealthy (see "What Will Put You in the AMT," page 109). And in the short run, the investor-friendly tax cuts have made preparing your taxes, never a pleasant task, that much harder.
First, the tax rate on long-term capital gains (held more than one year) was 20% through May 5, 2003; since May 6, the rate has been 15%. That midyear breakpoint complicates the way you net out your gains and losses. If you took capital losses at the end of 2003 to offset capital gains from earlier in the year, you may be in for an unpleasant surprise. Second, the widely heralded dividend rate cut created a minefield of tax traps. Qualified dividends are now taxed at 15% (for the entire 2003 tax year) instead of at marginal tax rates. But not all dividends are qualified--and even if yours are, you may not have owned the stock or fund that generated them long enough to get the 15% rate.
The result is that Schedule D (Capital Gains and Losses) is now 13 lines longer than it was last year and comes with its own 11-page instruction booklet. (See the facing page.) "It wasn't all that easy to start with and now it's certainly more complex," says Stuart Ritter, a financial planner at fund firm T. Rowe Price. "You have to pay for that tax reduction."
What does all this mean to you? You don't need to do anything different on your return to take advantage of the new lower income tax rates, including the expansion of the 10% bracket and the elimination of the so-called marriage penalty. Nor do the tax cuts change most of the usual rules of smart tax filing: Claim all the credits you can, such as the child credit and dependent-care credit. Make sure you know whether you'll do better by claiming the standard deduction (now $9,500 for married couples filing jointly, $4,750 for singles) or by itemizing. Don't forget to write off all your charitable contributions, including the old clothes you donated to Goodwill. And use those tax breaks offered for retirement savings and education.
But Schedule D presents new and nightmarish challenges. Read on for advice on how to navigate them without having to fear that the Internal Revenue Service will come back to haunt you. And then take our advice: If you've got more than a few very simple transactions, hire an accountant, buy tax software or prepare your return online. You'll be glad you did. Really.
Item No. 1 Gains and losses
The general principles of handling capital gains and capital losses haven't changed. The IRS allows you to use capital losses to offset an equal amount of capital gains. Once you've matched those gains and losses (first short-term with short-term, and long-term with long-term), you can book a $3,000 net capital loss against your regular income. You should do this each and every year you have losses in your portfolio.
Jason Eng, a 26-year-old software engineer from Alameda, Calif. has a fairly simple capital-gains story. Eng is enrolled in an employee stock-ownership plan, or ESOP, that allows him to buy shares in his publicly traded employer, Wind River Systems, twice yearly at a discount. Last August, Eng sold about 1,750 of those shares, purchased at various prices over the previous year and a half, for nearly $11,000. "I used the money for a down payment on a car," says Eng, who's now driving a new Acura. For tax purposes, the sale was a mix of long-term and short-term capital gains; he hasn't yet received the Form 1099-Bs that will detail the proceeds, but Eng figures he'll end up with a $3,000 short-term gain and a $1,000 long-term gain. Because he took no losses against those gains, the short-term gain will be taxed at his marginal income tax rate--just as it would have been last year--and the long-term gain will be taxed at the new 15% rate.
What makes Eng's case relatively uncomplicated is that he sold those shares after May 5. If, like Eng, you did your selling after May 5, your case is also simple. Let's say that in July you sold shares of ABC Corp. for a long-term gain of $1,000 and shares of XYZ Corp. for a long-term loss of $500. You'd book a $500 net long-term gain, which would be taxed at 15%--a $75 tax hit.
If all of your sales came before May 6, it's easy too (though a bit more expensive). For the same sales in February, you'd still book a $500 net long-term gain, but it would be taxed at the old 20% rate--a tax of $100.
But straddle those two periods--especially if you've got a mix of long-term and short-term gains from both before and after that May 5 breakpoint--and "you could end up with some strange results," says Mark Luscombe, federal tax analyst at tax publisher CCH.
OUR ADVICE As you work your way through Schedule D, you'll have to report your capital gains and losses from after May 5 twice--once as part of your yearlong totals and once separately. As in the past, you begin by matching all of your gains and losses for the year, short-term gains against short-term losses, and long-term gains against long-term losses. Then you match your gains and losses from after May 5. If you have a long-term gain for the year, you must also calculate your gain or loss from before May 6. This calculation won't change your net gain for the year--but it may very well change the rate at which it's taxed.
Item No. 2 Tax loss selling
One possible surprise from this netting nightmare is its effect on tax loss selling you did in late 2003. As Bob Rywick, a senior tax analyst at tax publisher RIA, explains, "The provisions of [the 2003 tax package] say that post-May 5 short-term capital losses offset post-May 5 long-term capital gains." So if you had gains throughout the year, the losses you took in December may offset the gains that are taxable at 15%, but not those taxable at 20%. "It is bizarre," says Rywick, "but that is the way the statute reads."
Consider this example from Susan Hirshman, a planning strategist at J.P. Morgan Fleming Asset Management: In February, you sold shares of ABC Corp. for a short-term gain of $1,000 and shares of XYZ Corp. for a long-term gain of $700. Then in September, you sold more ABC stock, this time for a short-term loss of $1,500, as well as more XYZ shares, this time for a long-term gain of $1,800. When you net everything out for the whole year, you have $2,500 in long-term capital gains and $500 in short-term losses, yielding a $2,000 net capital gain.
But what's the tax rate on your gain? You might think that since you took the bulk of the gains after May 5, the bulk of your taxes would be calculated at the 15% rate. You'd be wrong. When you net out your pre-May 6 gains separately, you end up with a $1,700 gain at the 20% tax rate and a mere $300 gain at 15%. The result: a tax bill for $385 instead of $310. "It seems illogical," Hirshman points out. Indeed.
OUR ADVICE Rely on any of the major tax software programs--or an accountant--to work through these netting complications for you. (See "Tax Software, Online Programs" on page 104.) And don't be shocked if the results don't seem to make sense.
Item No. 3 Carryovers
During the bear market, one smart tax move was to bulk up on capital losses, since the IRS allows you to stockpile them for the future. That's precisely what Peter Rabbino, a 37-year-old Miami computer consultant for law firms, and his wife Hunter Reno, 35, a television show host, did in 2002. With investments in WorldCom and some other former high fliers floundering, they booked an $18,000 net capital loss. "I had a portion of my portfolio in volatile stocks," Rabbino recalls. "I watched them go up and had a great time, and then watched them go down and needed to take a write-off." So last year they used $3,000 of that net capital loss against their income, according to their accountant, Terry Santini, and carried forward the remaining $15,000 to this year. Now Rabbino and Reno can use the carryover to offset their capital gains and $3,000 of their income for 2003--and they can continue doing this until they have exhausted their carryover.
The 2003 tax cuts may affect your carryover in one way you may not have thought much about. If you're carrying forward a long-term loss that you took when the capital-gains rate was 20% and you took no gains until the lower 15% rate kicked in, your carryover is worth less to you.
OUR ADVICE If you have a capital-loss carryover for 2003, it nets out like any other long-term or short-term capital loss. If the net result is a loss, use it to offset the highest tax rate first. Begin by offsetting any gains that are taxable at 28% (gains from the sale of collectibles) or 25% ("unrecaptured section 1250 gains" attributable to depreciation on investment property, including that held in real estate investment trusts, or REITs). Next match the carryover against long-term gains from before May 6, which are taxed at the old 20% rate, and finally against long-term gains from May 6 or later, taxed at the new 15% rate.
Item No. 4 Qualified dividends
Before last year's tax cut, all dividends were taxed as income at marginal income tax rates. Now "qualified" dividends are taxed at just 15%. If you're in the 35% tax bracket (today's top rate) and have $1,000 in dividend income, that's the difference between owing $150 and owing $350--a 57% savings.
Eric McPherson, a 36-year-old divorced father of two in Hollywood, Fla., is one beneficiary of that rate cut. He's socked away about $200,000 in a taxable account with T. Rowe Price that comprises 13 different mutual funds, a portfolio that he set up in 2003. "I had been about 70% in cash before, so I am pretty tickled pink," says the franchise manager. From that array of funds, McPherson says, he collected almost $1,500 in dividends in 2003. Assuming that all those dividends are qualified and that he has met the holding period criteria--two big ifs, which we'll discuss below--he would owe just 15% tax on those dividends, or roughly $225.
What makes a dividend "qualified"? Dividends from most domestic and foreign stocks, including ADRs, count as qualified. But those paid by REITs or by the majority of preferred stocks (which technically are structured as bonds, not as equities) do not.
For mutual funds, the rules are more complicated, because many different types of payments are termed dividends. If the dividends are simply those paid out by stocks held in the fund and passed through to investors, they qualify for the lower rate. If they are dubbed "dividends" but are really short-term capital gains, interest from bonds and such, they do not. At tax time, you'll need to look at your Form 1099-DIV and see whether the dividends you received are listed in box 1a (ordinary dividends) or in 1b (qualified).
And there's one more catch: Even those dividends reported as qualified may not be qualified to you. "You need to work through which of the qualified dividends you received from a mutual fund are actually qualified based on the holding period," says Martin Nissenbaum, national director of personal income tax planning at Ernst & Young.
Here's the holding period rule: To get the 15% rate, you must have owned the stock or fund for more than 60 days within a 120-day window around the ex-dividend date. (Dividends are paid to investors who hold the stock on the ex-dividend date.) Let's say that you bought 5,000 shares of XYZ Corp. on July 1. The company announced a 10¢ cash dividend, and the ex-dividend date was July 9. You then sold the shares on Aug. 4. Your 1099-DIV would show $500 in qualified dividends. However, since you owned the shares for only 34 days of the 120-day period around the ex-dividend date (in this case, from July 2 through Aug. 4), you would not have any qualified dividends.
This rule--like the wash-sale rule before it--is almost guaranteed to trip up a lot of investors. It's especially hairy if you've taken advantage of automatic purchases and dividend reinvestments, an investing strategy we've long recommended. Some of your dividends could be qualified and some not.
To make things worse, there's a glitch in the way the holding period rules were written. The theory behind the rules is that they would stop anyone from getting the dividend at that low 15% rate and immediately unloading the stock for a short-term capital loss. But if you buy on the day before the ex-dividend date, "you can hold the shares until the cows come home, even the mad cows, and you still won't have a qualified dividend," as tax attorney Kaye Thomas writes in one of the few comprehensive explanations of the problem. The reason: For tax purposes, your holding period includes the day you sell but not the day you buy--and so you simply run out of time within the 120-day window. While a technical corrections bill that would fix this problem (by adding one day to the 120-day window) is now pending in Congress, don't count on it yet. In fact, the IRS' own instructions to Form 1040 are quite clear on this point. In an example printed there, if you buy shares of XYZ Corp. on the day before the ex-dividend date and sell those shares 63 days later, "you have no qualified dividends... because you held the stock for only 60 days of the 120-day period."
OUR ADVICE If you're a buy-and-hold investor, following the qualified-dividend holding period rules won't be too onerous. But if you're an active trader and you do your own taxes, you have one more reason to use software that can track the details of all of your investments. (See the box on page 104.) Finally, if you did sell any shares of stock or funds last year that you purchased on the ex-dividend date, don't rush to file your return. There's always a chance that Congress might pass the fix before April.
Two more items
The tax cuts created additional complications for some investors. Among them are the now-defunct extra-long-term five-year capital gains rate and--by far the most serious--the interaction of the reduced rates on long-term capital gains and qualified dividends with the alternative minimum tax.
The special five-year capital-gains rate (8% for the two lowest income brackets, 18% for others) disappeared as of May 6 with the arrival of the new lower long-term capital-gains rates. For the 2003 tax year, the only ones who can take the five-year-gain rate are low-bracket filers. If you--or your kids--sold stocks or funds before May 6 that qualified for the five-year rate, that gain will net out along with the other capital gains and losses on Schedule D.
But you're out of luck if you positioned your portfolio back in 2001 to take advantage of an 18% rate on extra-long capital gains that was slated to take effect in 2006. The reason: To be eligible for that rate, you had to declare those shares sold and repurchased, through what's called a "deemed sale." At that time, you paid tax on the gains on those shares at the 20% rate. Even though today's rates are lower, you cannot undo that move.
A far greater worry is the AMT. Ironically, the 2001 and 2003 tax cuts magnified the risk--already rising--that you will eventually be hit by this alternate tax, which has its own rates and its own rules on deductions and add-backs. This year, more than 2 million taxpayers are expected to pay the AMT; the Urban-Brookings Tax Policy Center expects that number to hit 33 million by 2010.
While the new 15% tax rates for long-term capital gains and qualified dividends apply to both the regular tax system and the AMT, they may work out quite differently. Take the way the 15% rates interact with the AMT exemption phaseout. The AMT exemption (currently $58,000 for married couples filing jointly and $40,250 for singles) phases out at a rate of 25¢ on the dollar above $150,000 for marrieds and $112,500 for singles. That means each additional dollar in income effectively adds $1.25 to the income on which you are taxed.
Assume that you book a $1,000 long-term capital gain after May 5 and have no offsetting losses; your capital-gains tax is $150. But if you're an AMT payer with AMT taxable income of, say, $160,000, you have lost $250 of your exemption. If you're in the 28% AMT tax bracket, that means an extra $70 in tax, putting your total tax on that gain at $220, or 22%.
Confused? When it comes to the AMT, everyone is. That's another reason to hire an accountant or invest in software or an online tax program. You'll have more time--and the peace of mind--to enjoy the benefits of the latest round of tax cuts.