Workshop Portfolio

Foolish Workshop

Such Problems We Should Have!
Tax considerations of capital gains

By Todd Beard (synchronicity)


Des Plaines, IL (Oct. 28, 1999) --Last week we covered some basics of estimating our after-tax returns from various Workshop strategies. This week's focus is a related issue, namely paying those taxes that come due on our returns, possibly during the tax year. These payments are called "estimated tax payments."

First, I need to state the DISCLAIMER -- Yes, I am a tax lawyer, but I DON'T play one here at The Motley Fool. The following should not be construed as legal advice, relied upon for financial or tax planning, or taken as a substitute for thorough research into these issues. Here, I'm just a layman Fool sharing my limited knowledge with the rest of you. Please be sure to consult your attorney/accountant/whomever and get complete information before taking any action. For Paperwork Reduction Act notice, see separate publication.

Why would we have to worry about "estimated taxes"? Although we only think about our tax bill in early April, in reality we have to pay our tax liability in roughly equal amounts throughout the year. For most of us, this is taken care of automatically through the wonders of wage withholding. However, if we have a bunch of extra income with no taxes withheld, such as capital gains generated by a Workshop strategy, then the IRS may charge us a penalty for not paying enough in taxes during the year.

With any luck, our Workshop screens will supply us with lots of extra income. As the old saying goes: Such problems we should have!

So how does this work? Let's say that last year you had a federal tax liability of $9,500, and this year your tax liability will be $11,000. You will have no penalty as long as your total taxes withheld (wage withholding) are at least:

  1. 100% of last year's tax liability ($9,500 in our example);
  2. 90% of your current year's tax liability (0.9 *$11,000, or $9,900); or
  3. Within $1,000 of your total tax liability ($11,000 less $1,000, or $10,000).
In the example above, the lowest amount is $9,500 (last year's tax liability). This amount is known in tax circles as a "safe harbor"; if at least $9,500 was withheld, then you're safe from any penalties. I know, I know, most of us won't know our current year's tax liability until about April 10. Just keep reading for now.

What happens in the case above if you had only $8,000 in taxes withheld? You can either pay an extra $1,500 to the IRS as "estimated tax payments" during the year, bringing you up to your safe harbor amount of $9,500, or you can pay all your additional taxes in April as usual and get stuck with a penalty.

Estimated tax payments are due four times during the year, on the 15th of April, June, September, and the following January. On each date you will have to pay at least one-fourth of the "safe harbor" amount. The IRS assumes your wage withholding is spread equally over each quarter unless you specify otherwise. In other words, if $2,000 is withheld in the first quarter, the IRS assumes your withholding for the year will be around $8,000.

In our example above your "safe harbor" amount is $9,500, and you are withholding at a rate of $8,000 per year. On April 15 you would owe $2,375 (one quarter of $9,500), and would only have paid $2,000 through withholding. So, to avoid any penalty, you would need to pay an additional $375 to the IRS by April 15. You would repeat the process in June, September, and then in January. When you file your return the following April, you would owe the difference between your final tax liability ($11,000 in our example) and the amounts you've paid (you've paid $9,500 through withholding and estimated tax payments combined), so you'd owe an additional $1,500 on your return.

That's an awful lot of work. What happens if you get stuck owing a penalty when you file your return? Here's the good news: The "penalty" is simply an interest charge on the amount of underpaid tax. The interest is based on the difference between your safe harbor amount and what you actually paid, not the total that you owed. That interest rate is currently only about 7-8%!

Since many of our workshop screens have returned over 20% annually, you may be better off keeping your cash in the strategy than making estimated tax payments during the year. (In essence, Uncle Sam is extending you a loan at 7% during the year.) Also, the penalty amount will be quite small compared to your overall tax burden. In the example above, your estimated tax "penalty" (according to last year's Form 2210) would be all of $76.

Whatever you do, be sure to pay your taxes on time (before the normal April 15 deadline), otherwise the REAL penalties kick in. From a practical standpoint, you (or your accountant) should estimate your final tax liability shortly after year-end and be sure that you have enough cash set aside to pay it. Remember that only long-term funds should be in the market, not money that you'll need in three months to pay the IRS. The last thing you want is for the market to tumble, leaving you with a big tax bill in 1999, no money to pay it, and big capital losses for the year 2000. Ugh.

For more information on estimated taxes, I strongly recommend going to the IRS website and downloading Publication 505. Also note that many states have similar rules regarding estimated taxes. There are other issues that were not addressed above, such as the "annualization" method for calculating estimated taxes. (Roughly, you figure how much you earned each quarter, and only pay taxes on that. It works great if you have a lot of capital gains late in the year.) Also, people with over $150,000 in adjusted gross income have slightly different "safe harbor" rules. We wouldn't want anything to be too simple!

Feel free to check out the Tax Strategies message board for more information, or stop by the Foolish Workshop message board to comment on this or many other issues.

Until next week, Fool on!

New Rankings | Workshop Returns


Workshop Portfolio


9/28/01 as of ~5:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AETAETNA INC NEW0.943.36%28.94
BABOEING CO(1.04)(3.02%)33.36
CATCATERPILLAR INC1.112.53%44.91
COGCABOT OIL & GAS 'A'0.693.59%19.90
DDDU PONT (EI) DE NEMOURS0.992.74%37.14
DGXQUEST DIAGNOSTICS(0.45)(0.73%)61.42
EKEASTMAN KODAK0.421.31%32.49
GMGENERAL MOTORS1.393.38%42.55
LHLABORATORY CORP AMER HLDG(NEW)1.141.42%81.21
MOPHILIP MORRIS COS(0.76)(1.55%)48.24
NEWPNEWPORT CORP0.261.90%13.97
NVRNVR INC(0.54)(0.38%)140.41
PKXPOHANG IRON & STEEL ADS1.097.51%15.61
PVNPROVIDIAN FINANCIAL1.075.64%20.04
QCOMQUALCOMM INC(0.40)(0.84%)47.16
RJRRJ REYNOLDS TOBACCO HLDGS(0.69)(1.19%)57.31
SLESARA LEE CORPUnchg.Unchg.21.09
UNFIUNITED NATURAL FOODS0.563.18%18.15
WMIWASTE MANAGEMENT(0.01)(0.04%)26.74

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(12/24/1998)
Workshop1.30%7.32%(12.02%)(20.66%)(18.91%)
Comparable S&P 500n/an/an/an/a(19.07%)
S&P 500 (DA)1.95%7.48%(8.33%)(21.22%)(14.88%)
NASDAQ2.02%4.71%(17.46%)(39.68%)(31.41%)
DJIA (DA)1.68%7.07%(11.07%)(17.86%)(2.22%)

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (12/24/1998)
Workshop(17.62%)
vs. S&P 500(17.63%)

Trade Date # Shares Ticker Cost/Share Price Total % Ret
1/8/0126MO40.9448.2417.82%
1/8/0122RJR50.1057.3114.39%
1/8/0167UNFI16.4518.1510.34%
12/24/9824CAT43.0844.914.24%
1/8/018NVR136.63140.412.77%
1/8/0140WMI27.4426.74(2.54%)
1/8/0150SLE22.5421.09(6.42%)
1/8/0161PKX17.8315.61(12.46%)
1/8/0115DD48.8337.14(23.95%)
1/8/0129AET38.1728.94(24.19%)
1/8/0139COG28.7519.90(30.79%)
1/8/0114QCOM75.5447.16(37.57%)
1/8/018LH134.6981.21(39.70%)
12/27/9918GM73.2642.55(41.92%)
1/8/0118BA59.5333.36(43.96%)
1/8/019DGX114.4961.42(46.35%)
12/27/9920EK65.0932.49(50.08%)
1/8/0120PVN55.5020.04(63.89%)
1/8/0115NEWP74.9613.97(81.36%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
1/8/0126MO$1,064.50$1,254.24$189.74
1/8/0122RJR$1,102.25$1,260.82$158.57
1/8/0167UNFI$1,102.12$1,216.05$113.93
12/24/9824CAT$1,034.00$1,077.84$43.84
1/8/018NVR$1,093.00$1,123.28$30.28
1/8/0140WMI$1,097.50$1,069.60($27.90)
1/8/0150SLE$1,126.88$1,054.50($72.38)
1/8/0161PKX$1,087.75$952.21($135.54)
1/8/0115DD$732.50$557.10($175.40)
1/8/0129AET$1,107.00$839.26($267.74)
1/8/0139COG$1,121.37$776.10($345.28)
1/8/0114QCOM$1,057.62$660.24($397.39)
1/8/018LH$1,077.50$649.68($427.82)
1/8/0118BA$1,071.50$600.48($471.02)
1/8/019DGX$1,030.44$552.78($477.66)
12/27/9918GM$1,318.62$765.90($552.73)
12/27/9920EK$1,301.75$649.80($651.95)
1/8/0120PVN$1,110.00$400.80($709.20)
1/8/0115NEWP$1,124.37$209.55($914.83)
 
Cash: 
Total: 
$10.80
$15,681.03
 

Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.
• DJIA (DA) = dividend adjusted. Dividends have been added to the total return of the DJIA.

Note
Note: The Workshop Portfolio was launched on December 24, 1998, with $4,000 which was invested in the Foolish Four strategy. Approximately $15,000 was added on January 8, 2001, to support five additional mechanical strategies. At that time approximately $1000 was transfered out of the Foolish Four strategy to bring the Foolish Four into balance with the other strategies. (That's why the Foolish Four's overall return is not consistent with stock values.) Such rebalancing will take place each year among the strategies so that each will start out with approximately the same value at the begining of the year. No more cash additions are planned. The first four tables above show the overall performance of the portfolio. Below that we also track the performance of each component strategy. All transactions are announced publicly before being made, and returns are compared daily to the S&P 500 and the Dow. (Dividends are included in the yearly, historic and annualized returns.) Stocks are chosen using strategies developed by the Workshop community.