Cash dividends

Qualified cash dividends received from stocks are taxed at a maximum rate of 0 percent, 15 percent, or 20 percent depending on the investor’s adjusted gross income (AGI). Qualified dividends are ones in which the customer has held onto the stock for at least 61 days (91 days for preferred stock). The 61-day holding period starts 60 days prior to the ex-dividend date (the first day the stock trades without dividends). If the investor has held the stock for less than the 61-day holding period, the dividends are considered nonqualified and investors are taxed at the rate determined by their regular tax bracket.

Stock dividends

Stock dividends don’t change the overall value of an investment, so the additional shares received are not taxed (for details, see Chapter 6). However, stock dividends do lower the cost basis per share for tax purposes. The cost basis is used to calculate capital gains or losses.

Dividends from mutual funds

Dividends and interest generated from securities that are held in a mutual fund portfolio are passed through to investors and are taxed as either qualified (see the earlier section “Cash dividends”) or nonqualified. The type(s) of securities in the portfolio and the length of time the fund held the securities dictate how the investor is taxed. Here’s how mutual fund dividends are taxed:

• Federally tax free: Municipal bond funds
• 0, 15, or 20 percent: Stock funds, long-term capital gains
• Ordinary income: Corporate bond funds, short-term capital gains

One of the great things about owning mutual funds is that they’re nice enough to let you know what taxes you’re going to be subject to. At the beginning of each year you will receive a statement from the mutual fund that lets you know how much you received the previous year in dividends, in short-term capital gains, and in long-term capital gains. The mutual fund also sends a copy of the statement to the IRS.

The mutual fund determines the long-term or short-term gains by its holding period, not the investors’. Also, remember that you’d be subject to capital gains tax and taxes on dividends even if the money were reinvested back into the fund.

Incurring taxes with capital gains

An investor realizes capital gains when he sells a security at a price higher than his cost basis. Capital gains on any security (even municipal and U.S. government bonds) are fully taxed on the federal, state, and local level.

A capital gain isn’t realized until a security is sold. If the value of an investment increases, it's considered appreciation or an unrealized gain and if investor doesn’t sell, the investor doesn’t incur capital gains taxes.

Capital gains are broken down into two categories, depending on the holding period of the securities:

• Short-term capital gains: These gains are realized when a security is held for one year or less. Short-term capital gains are taxed according to the investor’s tax bracket.
• Long-term capital gains: These gains are realized when a security is held for more than one year. To encourage investors to buy and hold securities, long-term capital gains are currently taxed at a rate in line with cash dividends (0, 15, or 20 percent depending on the investor’s adjusted gross income). (For more information on capital gains and losses, visit the Internal Revenue Service’s website at www.irs.gov/taxtopics/tc409.)

Realized versus unrealized

Remember, a customer who owns a security will not realize a profit or loss until the security is sold. If the customer sold the security for less than the cost basis, he would have a loss; if he sold it for more than the cost basis, he would have a gain or profit. If, however, the customer purchased a security that is up in value over the cost basis but is still holding the security, it is considered an unrealized gain or appreciation. So the customer cannot have a gain or loss until the security is sold.

Cost valuation

If an investor purchased the same security being sold several times (monthly, yearly, or whatever), he can actually choose which securities are to be sold based on his tax situation. So let's say that Mr. Smith purchased 100 shares of DIM common stock once every 6 months over the last 4 years. Now, Mr. Smith sees an excellent opportunity to purchase a new penny stock but needs to sell 100 shares of his DIM common stock so that he has enough money for the purchase. If the price of DIM has been increasing over the last 4 years, he may decide to sell the first ones purchased, the ones purchased 3 years ago, the ones purchased 2 years ago, the ones purchased 6 months ago, and so on.

• FIFO (First In, First Out): In this scenario, when an investor purchased the same security being sold several times, the first ones purchased would be the first ones sold.
• LIFO (Last In, First Out): If an investor purchases the same security being sold several times, the last ones purchased would be the first ones sold.
• Identified Shares: In this case, if an investor purchased the same security being sold several times, he may choose to sell the securities purchased on a certain date or several dates.

You should be able to help your customers determine which of the following cost valuation scenarios would work best for them. Depending on the holding period of the securities, it could result in a long-term or short-term capital gain or loss. Also, the amount of capital gain or loss your customer would incur would be determined by which securities are being sold.

Determining the cost basis per share

The cost basis per share is what an investor paid to purchase the security plus commissions, markups, and any fees. So, certainly if the investor purchased 100 shares, you would have to divide the overall cost of the transaction by 100 to determine the cost basis per share. What can really throw a wrench into the works is when an investor exchanges convertible securities into common shares, or receives stock by way of dividend or split.

To determine the cost basis per share on a straight transaction of stock, just divide the cost basis by the number of shares purchased:

To calculate the cost basis per share on a security that has been converted, take a look at the following example:

Mr. Smithy purchases an ABC convertible bond at an overall cost of $980 including commission and fees. Mr. Smithy decides to convert his bond into ABC common stock. If the conversion price is $20, what is Mr. Smithy's cost basis per share?

Assuming that the par value of the bond is $1,000, you have to get the conversion ratio:

Next, divide the overall cost by the conversion ratio to get the cost basis per share:

The process works the same whether dealing with convertible bonds or convertible preferred stock. Also, be careful because sometimes the conversion ratio may already be given in the question, so you'll be able to skip a step.

Next, you'll have to determine the cost basis per share on stock splits. Look at the following example. (Stock splits were covered in the Securities Industry Essentials exam.)

Mrs. Smithy purchases 200 shares of ABC common stock with an overall cost of $12,400 including commission and fees. ABC declares a 2-for-1 split to shareholders of record on August 4. What is Mrs. Smithy's cost basis per share after the split?

I think that the best way to handle this one is to determine the original cost basis per share prior to doing the split first:

The overall cost basis for the initial transaction is not going to change but, since the company is calling for a 2-for-1 stock split, this investor is now going to have 2 shares for every 1 that she had previously. So if the amount of shares gets doubled, the cost basis per share has to get cut in half:

The way you determine the cost basis per share due to stock dividends is very close to the way you determine the cost basis per share on stock splits. If you'd like to see an example, you can visit Chapter 6.

Securities to be delivered on a when issued (WI) basis have not established a dollar amount yet. So for tax purposes, it is impossible to figure out the cost basis for WI securities.

Net yield after capital gains tax

Remember, capital gains on any security (including municipal securities) is taxed. To determine the net yield after capital gains tax, you first have to determine the capital gains yield. Look at the following equation where the investor bought the security for $50 and sold it at $55:

Next, let's assume that the investor had held the security for over one year, so it's a long-term capital gain. If the long-term capital gain was taxed at 20 percent, what would be his net yield after capital gains tax?

For this investor, even though he had a capital gains yield of 10 percent, after paying capital gains tax, his net yield was only 8 percent.

1.0 on your calculator is equal to 100%, 0.80 is equal to 80%, 0.10 is equal to 10%, and so on.

Offsetting gains with capital losses

An investor realizes a capital loss when selling a security at a value lower than the cost basis. Investors can use capital losses to offset capital gains and reduce the tax burden. As with capital gains, capital losses are also broken down into short-term and long-term:

• Short-term capital losses: An investor incurs these losses when he has held the security for one year or less. Investors can use short-term capital losses to offset short-term capital gains.
• Long-term capital losses: An investor incurs these losses when he has held the security for more than one year. Long-term capital losses can offset long-term capital gains.

When an investor has a net capital loss, he can write off $3,000 per year against his earned income and carry the balance forward the next year.

The following question involves capital-loss write-offs.

The wash sale rule: Adjusting the cost basis when you can’t claim a loss

To keep investors from claiming a loss on securities (which an investor could use to offset gains on another investment — see the preceding section) while repurchasing substantially (or exactly) the same security, the IRS has come up with the wash sale rule; according to this rule, if an investor sells a security at a capital loss, the investor can’t repurchase the same security or anything convertible into the same security for 30 days prior to or after the sale and be able to claim the loss. An investor doesn’t end up in handcuffs for violating the wash sale rule; he simply can’t claim the loss on his taxes.

However, the loss doesn’t go away if investors buy the security within that window of time — investors get to adjust the cost basis of the security. For instance, if an investor were to sell 100 shares of ABC at a $2-per-share loss and purchase 100 shares of ABC within 30 days for $50 per share, the investor’s new cost basis (excluding commissions) would be $52 per share (the $50 purchase price plus the $2 loss on the shares sold), thus lowering the amount of capital gains he would face on the new purchase.

The following question tests your understanding of the wash sale rule.

Accretion

When investors purchase bonds at a discount, the discount must be accreted over the life of the bond. Accretion, which involves adjusting the cost basis (price paid) of the bond toward par each year that the bond is held, increases both the cost basis of the bond and the reported interest income.

To determine the annual accretion, find the difference between the cost of the bond and par value; divide the result by the original number of years to maturity.

The following question tests your understanding of accretion.

Be prepared to answer questions about the annual accretion and yearly reported income and to calculate the capital gain or loss the investor would incur if selling the bond before maturity.

The following question tests your ability to figure out the capital gain or loss on a bond purchased at a discount.

Ms. Jones purchased a 7 percent DEF corporate bond at 80 with 10 years to maturity. Six years later, Ms. Jones sold the bond at 85. What is the gain or loss?

(A) $50 gain

(B) $70 loss

(C) $150 loss

(D) None of the above

The answer you’re looking for is Choice (B). First, adjust the cost basis of the bond in the time the bond matures:

The bond was purchased at $800 (80 percent of $1,000 par) and matures at $1,000 par in ten years. Next, take that $200 difference and divide it by the ten years to maturity:

Then take the $20 per year accretion and multiply it by the number of years that the investor held the bond:

Next, add the total accretion to the purchase price of the bond to determine the investor’s adjusted cost basis:

After that, compare the adjusted cost basis to the selling price to determine the gain or loss:

Ms. Jones incurred a $70 capital loss on her sale of the DEF bond, which she can use to offset capital gains on other investments (see the earlier section “Offsetting gains with capital losses”).

All discount bonds, except municipal bonds purchased in the secondary market (outstanding bonds), are accreted. If a municipal bond is purchased as an original issue discount (OID), the accretion is treated as part of the tax-free interest. If an investor purchases a municipal bond in the secondary market at a discount, the bond is not accreted, but the difference between the purchase price and the selling price (or redemption price) is treated as a capital gain.

Amortization

When bonds are purchased at a premium, the premium can be amortized over the life of the bond. You amortize the bond by adjusting the cost basis of the bond toward par each year that the bond is held; amortization decreases the cost basis of the bond and decreases the reported interest income.

To find the yearly amortization, divide the difference between the purchase price and par value by the original number of years to maturity.

The following question involves annual amortization:

Corporate bondholders can elect to amortize their premium bonds or not; however, all municipal bondholders must amortize their premium bonds, whether they were purchased as a new issue or in the secondary market (outstanding).

You can use the same basic formula that you use for accretion to determine the gain or loss on an amortization problem (see the preceding section). Only the first couple steps change. You still take the difference between the purchase price and par value and divide it by the number of years until maturity, which gives you the annual amortization. Then you multiply the annual amortization by the number of years the investor held the bond. At this point, you need to subtract that amount from the purchase price instead of adding it to the purchase price to get the adjusted cost basis. Then, as you do with accretion problems, you compare the adjusted cost basis to the selling price to determine the gain or loss.

Mary Johnson purchases 100 shares of LLL common stock at a price of $60 per share. She gives the securities to her son Zed when the market price is $75 per share. What is Zed’s cost basis per share?

(A) $60 per share

(B) $67.50 per share

(C) $75 per share

(D) It depends on the holding period

The correct answer is Choice (A). Because LLL increased in value after the original purchase, Zed assumes his mother’s cost basis.

John Johnson purchased 1,000 shares of DIM Corp. common stock at $40 per share. DIM subsequently decreased in price to $30 per share, and John gave the securities to his father-in-law, Mike. Two years later, Mike sold the stock for $37 per share. What is Mike’s tax situation regarding the sale of the DIM stock?

(A) $30,000

(B) $35,000

(C) $37,000

(D) $40,000

The right answer is Choice (A). Because DIM decreased from the original purchase price, Mike assumes the cost basis of the DIM stock on the date of the gift, which was $30,000 (1,000 shares × $30).

Defined benefit plans

As the name implies, defined benefit plans are ones in which the employee knows how much he'll receive at retirement. These type of plans provide a fixed pre-established benefit for employees at retirement based on things such as length of employment, salary history, and so on. The benefits are not dependent on asset returns (even if the investments lose money, the defined benefit remains). So the employer assumes the investment risk. Typically, employers can contribute more to defined benefit plans than defined contribution plans and therefore the employer's tax deductions are higher. Because defined benefit plans are more complex, they are typically more costly to maintain than other plans.

All full-time employees who have worked for the employer for at least a year must be eligible. With defined benefit plans, the employer contributes most or all of the money, although some plans require employee contributions or allow voluntary employee contributions. Vesting can follow several schedules, but all full-time employees must be fully vested by seven years.

At retirement, the employee may receive either a lump-sum payment or monthly payments as established by the plan. In most cases, if the investor dies prior to receiving his expected benefits, any remaining benefits would be paid to the employee's beneficiary.

Defined contribution plans

Unlike defined benefit plans, the amount of money an investor receives at retirement will vary based on how the investments held by the plan perform. This type of plan allows for a set contribution (usually at each pay period) by employees. Defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans, and profit sharing plans.

401(k) plans

As stated previously, a 401(k) is a corporate retirement plan. With this type of plan, employees can contribute a percentage of their salary up to a certain amount each year (as such, it’s a defined contribution plan). Because it’s a qualified plan, the amount contributed by the employee into the 401(k) is deducted from the employee’s gross income. In addition, in most cases, the employer matches the employee’s contribution up to a certain amount (for example, 25 percent, 50 percent, and so on). The account grows on a tax-deferred basis, so everything withdrawn from the account at retirement is taxable.

403(b) plans

These are salary reduction plans for public school (elementary school, secondary school, college, and so on) employees, tax-exempt organizations, and religious organizations. These plans are also known as tax-sheltered annuities. As with 401(k)s, employees can elect to have a portion of their pay put into the retirement plan that’s tax deferred. However, unlike 401(k)s, the employer doesn’t match a percentage of the contributions. To be eligible, employees must be at least 21 years old and have been working for the employer for at least a year.

Stock purchase plans and stock option plans

Stock purchase plans allow investors to purchase shares of their own employers stock at specified times usually at a discount. Employees are usually allowed to contribute anywhere between 1 percent and 10 percent of their salary. These are payroll deduction plans because the money is taken directly out of the employee's salary typically once every six months or so during the purchase period. Employees may then sell the shares in the market or hold onto them. Depending on how the plan is structured, it may be qualified (pre-tax contributions) or non-qualified (after-tax contributions).

Stock option plans may be offered to employees instead of stock purchase plans. In this case, the employee is given an option to purchase the company stock at a stated price over a stated time period. Typically, the option is at the money at the time of the offering, meaning that the strike price for the option is equal to the current market price of the company's stock. Usually, there's a vesting period so that employees must be employed full time by the company for a certain number of years. Unlike standard options, these options are long-term and typically expire several years later. (For more on options, visit Chapter 12.)

Profit sharing plans

Profit sharing plans are a type of defined contribution plan. Only the employer may contribute to the retirement plan. During good years, the company will contribute a specified percentage of each covered employee’s salary to the plan. In years where the company has low earnings, they may skip the contributions entirely (decided by the board of directors). Contributions are tax deductible to the employer, and the money grows on a tax-deferred basis. The maximum annual contribution is the same as the SEP-IRA (25 percent of salary up to $55,000).

Because investors don’t pay tax on the money initially deposited or on the earnings, the entire withdrawal from a tax-qualified plan is taxed at a rate determined by the investor’s tax bracket, which is normally lower at retirement. Additionally, distributions taken before age 59½ are subject to a 10 percent tax penalty (10 percent is added to the investor’s tax bracket) except in cases of death, disability, first-time home buying, educational expenses for certain family members, medical premiums for unemployed individuals, and so on.

Deferred compensation programs

With deferred compensation programs, the employee agrees to delay receiving a portion of her salary until she retires, is terminated, is disabled, or dies. Theoretically, when she retires, she would be at a lower tax bracket and would pay less in taxes later than if receiving money currently. If unfunded (not secured by specific assets safe from creditors) and the company declares bankruptcy or goes out of business, the company is not required to pay the amount of salary deferred. She becomes a general creditor of the company and must wait for the company to pay other debts to see if there are any cash available or assets available that can be liquidated to raise money for the compensation. The employer only receives a tax deduction once the employee is paid. Because these are non-qualified plans, the employer may discriminate and not offer the plan to all employees.

457 plans

457 are also deferred compensation plans established by public school districts or 501(c)3 non-profit organizations. However, if a 457 plan is established for municipal employees, the plan must be qualified. In both cases, a person having a 457 plan could also have another retirement plan and make the maximum contribution into both plans. Employees may defer up to 100 percent of their compensation up to a rate determined by the IRS (indexed for inflation).

Because investors have already paid tax on the money initially deposited but not on the earnings, withdrawals from nonqualified plans are only partially taxed at the rate determined by the investor’s tax bracket. The investor is taxed only on the amount that exceeds the amount of the contributions made.

Traditional IRAs (individual retirement accounts)

IRAs are tax-qualified retirement plans, so deposits into the account are made from pretax dollars (they’re tax-deductible). IRAs are completely funded by contributions that the holder of the account makes. Regardless of whether individuals are covered by a pension plan, they can still deposit money into an IRA. Here’s a list of some of the key points of IRAs:

• IRAs may be set up as single life (when the owner is the beneficiary of the account), joint and last survivor (when the sole beneficiary of the account is his or her spouse and the spouse is more than ten years younger than the owner), or uniform lifetime (when the spouse is not the sole beneficiary or the spouse is not more than ten years younger than the owner).
• Permissible investments for IRAs include stocks, bonds, mutual funds, U.S. gold and silver coins, and real estate.
• The maximum contribution per person is $5,500 per year, with an additional catch-up contribution of $1,000 per person allowed for investors age 50 or older. Excess contributions are taxed at a rate of 6 percent until withdrawn.
• A husband and wife can have separate accounts with a maximum contribution of $5,500 per year each, whether both are working or one is working.

• Contributions into the IRA are fully deductible for individuals not covered by employer pension plans.

  If investors are covered by an employer pension plan, deposits into an IRA may or may not be tax-deductible. Although I think that the chances of your being tested on the values are slim, if an individual is covered by an employer pension plan and earns up to $63,000 per year ($101,000 jointly), deposits made into an IRA are fully deductible. The deductions are gradually phased out and disappear when an individual earns more than $73,000 per year ($121,000 jointly).

• When an investor starts to withdraw funds from an IRA, the investor is taxed on the entire withdrawal (the amount deposited, which was not taxed, and the appreciation in value). The withdrawal is taxed as ordinary income.
• Withdrawals can’t begin before age 59½, or investors have to pay an early withdrawal penalty of 10 percent added to the investor’s rate according to his tax bracket. An investor isn’t subject to the 10 percent tax penalty in cases of death, disability, first-time homebuyers, and a few other exceptions. Obviously, dead retirees won’t be making withdrawals, but their beneficiaries will be. In this case, the beneficiaries aren’t hit with the 10 percent penalty.
• Withdrawals must begin by April 1 of the year after the investor reaches age 70½ (the required beginning date, or RBD). Investors who don’t take their required minimum distribution (RMD) by that time are subject to a 50 percent tax penalty on the amount they should have withdrawn. The IRS provides minimum distribution worksheets to help you determine the amount that needs to be taken in order to avoid the penalty. (You can find them at www.irs.gov/retirement-plans/plan-participant-employee/required-minimum-distribution-worksheets.)
• Deposits into IRAs are allowed up to April 15 (tax day) to qualify as a deduction for the previous year’s taxes.

Roth IRAs

Anyone who doesn’t make too much money can open a Roth IRA. The key difference between a traditional IRA and a Roth IRA is that withdrawals from a Roth IRA are tax-free. However, deposits made into the Roth IRA are not tax-deductible (made from after-tax dollars). Provided that the investor has held onto the Roth IRA for over five years and has reached age 59½, he can withdraw money from the Roth IRA without incurring any taxable income on the amount deposited or on the appreciation in the account.

The maximum that an individual may contribute to a traditional IRA and Roth IRA is $5,500 per year combined (or $6,500 if over age 50).

Investors who have an adjusted gross income of more than $135,000 per year ($199,000 jointly) can’t contribute to a Roth IRA.

Simplified employee pensions (SEP-IRAs)

An SEP-IRA is a retirement vehicle designed for small business owners, self-employed individuals, and their employees. SEP-IRAs allow participants to invest money for retirement on a tax-deferred basis. Employers can make tax-deductible contributions directly to their employees’ SEP-IRAs. As of 2018, the maximum employer contribution to each employee’s SEP-IRA is 25 percent of the employee’s compensation (salary, bonuses, and overtime) or $55,000 (subject to cost-of-living increases in the following years), whichever is less. Employees who are part of the plan may still make annual contributions to a traditional or Roth IRA.

Transfer

A transfer is when a person decides to have his funds from one retirement plan transferred directly to another retirement plan of the same type while never taking possession of the funds. For example, let's say Mr. Smith is leaving ABC Corporation to go work for DEF Corporation. If both corporations have a 401(k), Mr. Smith can have the assets in his 401(k) moved directly from the trustee of ABC's 401(k) to the trustee of DEF's 401(k). Because Mr. Smith is not taking possession of the 401(k)'s assets, there is no limit placed on the amount of transfers that can take place in one year.

Rollover

An investor may also roll over funds received from one retirement plan into another. Using Mr. Smith again as an example, if Mr. Smith decided to take the funds from his 401(k) and deposit them into another qualified plan such as an IRA, it would be considered a rollover. Mr. Smith must roll over the money into another qualified plan within 60 days in order for it not to be taxed as a withdrawal. Rollovers may only be executed once every 12 months. With a rollover, if the check was made payable to Mr. Smith, the fund would've imposed a 20 percent withholding tax. If Mr. Smith had the check payable to the new trustee instead of his name, the withholding tax would not be imposed.