Even if you use a professional tax preparer to do your taxes, at the end of the day, you are ultimately responsible for the accuracy of your tax return. For this reason, you may still want to make a note of the most important points written up in this article and scan your tax return before sending it in to the tax authorities.
If you do prepare your own taxes, I would highly recommend purchasing a tax software package. After discounts and rebates, it probably won't cost you more than $40 to $50, and I think that especially this year the outlay qualifies as money well spent (plus you may be able to deduct it on your next return as a tax preparation fee).
Having said the above, let's get started on our tax preparation journey. The very first step to take is to assemble the requisite tax documents, such as W-2s, 1099s, etc. A quick tip here: unless you made contributions or withdrawals from your tax-sheltered accounts, don't throw those year-end statement(s) onto the pile (just file them away for your records). Once again, any interest or profits realized in IRAs, employer-sponsored retirement plans, annuities, etc. are not reportable and therefore, you don't really need to do anything with respect to the dividend or capital gain information shown on those year-end statement(s).
Now that you have segregated your year-end statements, you don't really need to read the remainder of the article if you have no taxable accounts (i.e., if all your assets are sitting in IRAs, annuities, etc.). But if you do, I think you'll find the following information helpful.
The Interest vs. Dividend Quandary
Let's face it ? we're all creatures of habit but unless you unlearn lumping interest and dividends together, you will fall into a trap that'll cause you to overpay on your taxes! That is because the so-called qualifying dividends (see more below) are taxed at capital gains rates (max 15%) vs. the ordinary income rates that still apply to interest.
Now, what's a `qualified dividend'? In order to qualify for the preferential treatment, a dividend must be paid by a domestic or `qualified foreign' common stock or preferred stock. However, the holding-period rules have been changed by certain provisions of the Tax Technical Corrections Act of 2003: a common stock must now be held for a minimum of 61 days during a 121-day `window' that begins 60 days before the ex-dividend date, and in case of preferred, for 91 days during a 181-day `window' that begins 90 days before the ex-date (vs. 60/120 and 90/180 before).
The significance of adding that one extra day to the holding period is that a stock bought on the last day before the ex-dividend date (the latest purchase date for collecting a dividend) can still meet the holding period test for that dividend, since there are 61 days left in the 121-day period. A stock sold on the ex-dividend date (the earliest selling date after entitlement to a dividend) can also meet the test, since that is the 61st day in the period. So if a taxpayer holds a stock for at least 61 continuous days, the holding period test will be met for any dividend received, (unless the risk of loss was diminished).
Now that we have discussed in detail the qualification rules that apply to dividends, it would be a good place to clarify that mutual funds must meet the holding period test for the dividend-paying stocks that they hold in order for corresponding amounts that they pay out to be reported as qualified dividends on Form 1099-DIV. Investors must then meet the test relative to the shares that they hold, from which they received the qualified dividends that were reported to them. What the foregoing sentence means is that even though a given fund distribution may be shown as `qualified' on your 1099, you won't be entitled to the reduced tax rate if you held the shares of the fund for a shorter period of time than that stipulated in the regulations (oops ? another potential trap!).
And finally, one last caveat applicable to mutual fund distributions: it has come to my attention that in some cases, the characterization as qualified or non-qualified may not be shown on the year-end statement. In such case, you should not automatically assume that the distribution is non-qualified! The omission may result from the fact that the fund company didn't manage to transmit the information to your account custodian before the 1/31 deadline for generating 1099s. In such case, the information can be obtained from the given fund family's website or by calling their toll-free number. You may be as surprised as I was when ' on request from a client's accountant ' I tracked down this info for distributions paid by two funds that I didn't expect to generate qualified dividends and found that indeed a good percentage of each was eligible for the 15% tax rate.
Lastly, I would strongly advise waiting at least until the beginning of March to get started on your tax return. Now just why would a financial planner ever advise people to procrastinate? The reason is that & based on the experience of the last couple of years & corrected 1099s may be issued as late as the end of February or even the beginning of March. If you were to receive a corrected 1099 after already filing your return, you would need to amend it via Form 1040X (and potentially incur additional accountant fees if you use a tax preparer).
* Segregate the interest and dividends received in your taxable accounts;
* Ascertain which of your stock dividends are `qualified' and which are not, based on the payer and the applicable holding period;
* Check your 1099s to see which of your mutual fund dividends are reported as `qualified' and which are not (and possibly obtain the information for those distributions that are not characterized), then determine if you are eligible for the reduced rate based on the holding period of your fund shares;
* Wait with filing your tax return until you can be reasonably certain that no corrected 1099s will be issued.