Response to offline questions

Hi Fools –

I got a surprising number of offline questions to this post:… .

So I figured I’d answer them here…

Occasionally, I get lucky and the corrections bring the paperwork in line with any manual adjustments I had made on my own.

Q: What sort of corrections do you make on your own? And how do you know you’re getting it right and that your broker is wrong?

The corrections I make are mostly dividend-related ones. Some companies pay cash distributions that are not “normal” dividends. Often, the broker’s first publication calls everything a dividend and then corrects it later in a follow-up. If I’ve owned a stock for a while and it has had its distributions recharacterized in the past, I’ll usually check its investor relations web site and see how it is officially characterizing those payments. If my broker statement is out of line with the company’s site, I’ll go with what the company’s web site says.

Dividends also play a role in my corrections when I get “poached.” I invest in options spread strategies where I’ll be short a call option. If I’m not paying close enough attention near ex-dividend days and the underlying price conditions are right, a counterparty will exercise the call option and force me to be short the stock as it goes ex-dividend. That practice is known as “dividend poaching.” The capital gains or loss reporting on those transactions is incredibly complicated. They involve the options transaction to open, the stock transaction to close, and the treatment of the dividend payment itself. When I true-up from having been on the receiving end of a dividend poaching transaction, I double and triple check my records and my broker’s records and report what reality looks like from the actual transactions. When it’s reported wrong, usually the credit from the short call is missing from the proceeds or the dividend isn’t included in the basis or something like that.

get a guide on where I need to set my paycheck withholdings to stay within the prior-year safe harbor.

Q: What is a “safe harbor” and why do you try to stay within it?

The IRS doesn’t expect you to get your taxes perfect until the filing deadline (usually April 15), but it does expect you to get it close. There are generally three tests (known as “Safe Harbor” tests) it uses to judge whether you’re close enough. If, through withholdings or timely estimated payments you get:

  • to within $1,000 of what you owe for the year, you’re close enough.
  • to having paid at least 90% of what you owe for the year, you’re close enough.
  • to having paid at least 100% of what you owed for the prior year (110% if you’re considered high income), you’re close enough.

You have to pass at least one of those three tests, or you’ll face penalties on top of taxes due. For your reading pleasure on the topic, start with this IRS page: . Note that there are different tests for farmers & fishermen…

The first two tests require you to have a good idea of what your tax situation will look like for the current year before the year is over. The third – the “prior-year” safe harbor – is based on numbers known fairly early in the year. My “all in” income is fairly variable, and I usually don’t have a good grasp on where the year will shake out until September / October. So I’ll start by planning around the prior-year safe harbor. If I get a good sense that it’s going to be a bad year, I can cut back on withholdings later in the year to go after a different safe harbor test. If the variable income is down enough to where that shift is important, then having a higher base take home (from the lower withholdings) provides some much-appreciated relief.

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