Six questions to help advisors prepare for the 1099 season

Tis the season. Not the holiday season or Festivus, but the 1099 season. Most 1099’s are due to investors by January 31st. Receiving a 1099 often sets off a series of questions from investors to advisors about what happened during the year. Why do some numbers appear high or low and what does it mean for their tax bill? Like all things related to the Internal Revenue Service (IRS), the answer is that it depends.

Six questions to prepare for the 1099 season

1. What is the 1099?

There are more than ten versions of the 1099. For investors in mutual funds and ETFs, the 1099’s that likely matter the most are the 1099-DIV, 1099-INT, and 1099-B.

• 1099-DIV: Dividends, capital gain distributions, interest income from bond funds, and non-taxable income from municipal bond funds.
• 1099-INT: Interest income often from an institution such as a bank.
• 1099-B: Sales of stocks, bonds, funds, and ETFs during the year to include holding period
  info, cost basis, and proceeds from sales.

2. Do you need to know all the different 1099’s?

Not generally. Most Broker/Dealers or custodians will send a Consolidated 1099 that summarizes the information into a single document. Below is a sample 1099-DIV from a hypothetical Consolidated 1099.

3. Are the amounts on the 1099-DIV good or bad?

Again, it depends. Understanding the size of the investments behind the amounts can provide perspective. Also, it is helpful to know if the investor has an income need. If income is a portfolio goal, the amounts may make more sense.

• Line 1a Total Ordinary Dividends: Total amount of dividends and income received from mutual funds and ETFs. While the title says “dividends,” it also includes interest income from funds. But note that this line is not equal to the amount taxed.
• Line 1b Qualified Dividends: Amount of dividends and income that qualify to be taxed at long-term capital gains rates, which can be materially lower than ordinary income tax rates.
• Difference between 1b – 1a (Ordinary Dividends less Qualified Dividends): Generally, the difference between these two lines is taxed at ordinary income tax rates. This usually includes interest income and non-qualified dividends.
• Line 2a Total Capital Gain Distributions: Total capital gain distributions from mutual funds and ETFs. This includes both long-term and short-term distributions. Is this amount the taxable amount? No! These amounts are only part of the story for capital gains and losses.

4. Why aren’t the capital gain distributions on the 1099-DIV the taxable amount?

The IRS allows for combining and netting capital gains with capital losses. The total capital gain distributions on the 1099-DIV are only part of the story. Within the Consolidated 1099, there is also the 1099-B, which details the capital assets sold during the year. These sales will be netted as totals for Short Term Capital Gains and Long-Term Capital Gains. The details will show up on IRS Form 8949 with the totals on Schedule D.

The volatility of 2022 provided the opportunity for many actively tax-managed portfolios to possibly loss harvest (Top 5 Loss Harvesting Mistakes) by selling a capital asset for less than the adjusted cost basis of that security or fund. These harvested losses are netted against the capital gains shown on the 1099-DIV.

5. What if the capital losses are greater than the capital gain distributions?

For some investors, the losses harvested may be higher than the capital gain distributions. What happens, then? In most cases, the IRS allows taxpayers to deduct up to $3,000 of capital losses from taxable income. Interestingly this $3,000 limit is the same for couples filing jointly or single filers.  If they’re Married Filing Separately, they are limited to deducting $1,500 of losses.

For net capital losses of more than $3,000, taxpayers can carry forward the remaining capital losses into future years. These loss carryforwards should be viewed as tax assets for financial plans.

Capital loss carryforwards:

• Can be offset against gains in the following year(s).
• May allow for realigning the portfolio to preferred positioning and for risk management. Is there a holding you have been reluctant to sell due to the tax hit? This loss carryforward may allow you the cover to realign your portfolio purposefully.

6. Are capital gain distributions a bad thing?

It depends on the materiality and goals of the investor. At Frontier, we believe the goal for taxable investors is to maximize after-tax wealth – not to simply minimize taxes. These two differing goals are often in conflict. As we wrote last November (Blog -Tax-Smart Investing & Defining the Goal), there are examples of investments that create attractive pre-tax and post-tax returns—even in the presence of taxes. One cannot measure good/bad only on the distribution. You must understand the investment creating the distribution, the return, and the role in a globally diversified portfolio.

Frontier Asset Management in 2022

During 2022, we actively harvested losses throughout the year – not just at year-end. We do not look for funds to lose value, but we know there are market environments like 2022. And harvesting losses should not be limited to only equity funds. Given the path of interest rates in 2022, there were opportunities to tax-loss harvest for both stock and bond positions. Ensure your process is not limited to only certain portfolio parts. We hope the 1099/Schedule D conversation will be a bright spot in an otherwise challenging year in portfolio review discussions.

The goal is not only minimizing taxes but also maximizing after-tax wealth. During the 1099 season, remember it’s A (distributions) + B (net gains/losses) = taxable amount – if any.

Find out how Frontier’s tax-smart approach made a measurable difference for investors in 2022.

If you have questions about 1099 season or how to better prepare for your client conversations, we’re happy to help. Schedule a call.