Tax Issues

Substitute Dividend Payments in Margin Accounts

I have a margin account with  eOption for a couple of years now. When I first signed up, they have among the lowest margin interest rates in the industry, They have since adjusted the rates upwards, following the footsteps of Tradeking, Just2Trade, etc.

I spoke to customer service when the rates were first revised and they agreed to grandfather me to the more-friendly rate schedule. This more-friendly rate schedule is still available at their sister brokerage  The current rate is as follows:

The current Broker’s Call Rate is 2.00% as of 12/19/2008

Daily Average $ Debit Balance

Interest Rate

Less than 49,999 1.50% above broker call rate
50,000 to 99,999 .75% above broker call rate
100,000 to 249,999 at broker call rate
250,000 to 499,999 .50% below broker call rate
500,000 and above 1.00% below broker call rate

Anyway, I started taking advantage of their low margin rates but in the first quarter, I was hit with a substitute dividend payment in an ETF I was holding in that account. This is the definition of a substitute payment from Fidelity:

Substitute Payments
Substitute payments are payments received in lieu of dividends, interest, or other payments. They may be generated, for example, where a security has been lent to a third party (such as a broker) over a dividend record date. When an investor has a debit balance in a margin account, securities in the account are often eligible to be lent. If the shares are lent over a record date, the investor should receive a substitute payment equal to the amount of the dividend. Although the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) introduced lower federal tax rates for qualified dividend income, substitute payments are not taxed as qualified dividends but are instead taxed as ordinary income. Substitute payments in lieu of dividends and tax exempt interest are reportable in Box 8 of Form 1099-MISC.

So basically, with a substitute dividend payment, you get taxed at the full income tax rate instead of the preferential (15% for most tax payers) qualified dividend tax rate (if the dividend was originally qualified).

The negative consequence of this could be huge. For an ETF like VEA, I could get a year-end dividend in the range of a few thousand dollars. If it gets disqualified, my additional taxes could run into several hundred dollars.

There are a few ways to avoid this

  1. Move the assets to a brokerage that “gross-up” the dividends to compensate for the additional taxes you have to pay. I only know of two brokerages that have this voluntary program — Fidelity and TD Ameritrade. As far as I know, VBS (Vanguard) and WellsTrade do not offer this. eOption also does not offer this. Edit: Schwab also offers this voluntary “gross-up” program.
  2. Move the assets to the cash position. Some brokerages let you specify the “account type ” of each asset, whether it is “cash” or “margin”. eOption offers this and I moved the assets that potentially produce qualified dividends to “cash”. I left the non-dividend producing assets in “margin”. I don’t believe VBS lets you do this though; all the assets in each account must be the same “type” in VBS.
  3. Do not keep a debit balance. If we read Fidelity’s definition carefully, it says that if “an investor has a debit balance in a margin account, securities in the account are often eligible to be lent”. So technically if there is no margin balance, no shares should be loaned out. Personally, I do not regard this method as a fail-safe method. When you sign on the dotted line for a margin account, you are already giving permission to the broker to lend out your shares. It could be possible that the broker will refrain, as far as possible, from lending out your shares in this scenario, but I think there is no guarantee that this would never happen.

Note: FWIW, my experience is that method 3 seems to be true. Until the eOption experience, I have never received a substitute payment with the many margin accounts I have had over the years. The reason could be simply because I have never kept a margin balance except at eOption.



Less than 49,999 1.50% above broker call rate
50,000 to 99,999 .75% above broker call rate
100,000 to 249,999 at broker call rate
250,000 to 499,999 .50% below broker call rate
500,000 and above 1.00% below broker call rate

Reducing income during retirement to qualify for healthcare subsidy

The recent passage of the healthcare overhaul has prompted me to look closer at the issue of early retirement. There is a choice to work less and spend more time with family. Or even retire early and have the government subsidies your health care insurance by keeping income levels below 4x the poverty rate (see this Health Reform Subsidy Calculator).

The following is a list of items to reduce income:

  • If you have kids, and you want to help to pay for their college, plan to have more of it funded by 529 accounts. If you have to sell investments or draw down from tax-deferred accounts, that increases your MAGI.
  • Pay off mortgage if possible to eliminate income requirement. Again, same thing as college funding, if you have to sell investments or draw down from tax-deferred accounts, that increases your MAGI. Without a mortgage, you have less need to realize capital gains or draw down from tax-deferred accounts.
  • Derive income for ongoing expenses from tax exempt bonds (tax exempt income does not figure into MAGI).
  • Use a short term tax exempt fund to hold non-immediate cash needs instead of a high yield savings account. Perhaps top up the checking account once or twice a month. This reduces the amount of interest payments reported in MAGI.
  • Shift equity investments into lower yield equivalents, while still keeping the general composition of the portfolio reasonably unchanged. One potential candidate would be to invest in US LargeCap Growth instead of US LargeCap Blend. Does not work for US SmallCap (US SmallCap Growth has a poor historical record).
  • Invest in rental property and use rental income to fund ongoing expenses (rental income is typically offset by property depreciation).
  • Look into MLP investments that shield income for as long as the investment is not sold (you can control when to sell if necessary).
  • Delay signing up social security.

Even though it looks like I could potentially benefit from the healthcare reform if I retire early, I don’t agree with the changes. They simply penalize people who are successful and are a disincentive to work. This can’t be good for the economy. But that is another story.

Reduce your California tax withholding to avoid an IOU next April

As far as I know, California state has raised the tax withholding rates twice this year. The first was for payrolls starting from May 2009 and the second is for payrolls starting from November 2009. The latest increase is reported in this LINK.

If I remember correctly, the increase in May 2009 was due to the increase in the tax bracket from 9.3% to 9.55%. This led to the corresponding increase in withholding from 9.3% to 9.55%. This is a reasonable change (I am just saying that the change in withholding is logical; NOT that the increase in tax rate is in any way logical in a recession).

2009-11-02_CA tax old

Above: Tax withholding rates (before 11/1/09)

2009-11-02_CA tax new

Above: Tax withholding rates (from 11/1/09)

In the most recent increase, the withholding rate was increased by 10%. For most people, this  increases the withholding from 9.55% to 10.505%. There is no logical reason behind this; the only reason for this was that the state government wants an interest free loan from the tax payers.

Below are some comments reported in the LA times regarding this change:

“Many families are sitting at their kitchen table wondering how they’re going to make ends meet,” said state Sen. Tony Strickland (R-Thousand Oaks). “At the same time, the state of California is taking a no-interest loan.”

Such temporary measures as the withholding tax increase don’t really fix the budget gap, “they just more or less hid it,” said Christopher Thornberg, a principal with Beacon Economics in Los Angeles. “I call it a fraud.”

But there is a way out of this:

Savvy taxpayers can get around the state’s maneuver by increasing the number of personal withholding allowances they claim on their employer tax forms, said Brenda Voet, a spokeswoman for the state’s Franchise Tax Board.

“People can get out of this,” she said, noting that most people would have to change their allowances through their employers. California’s budget leaders are banking on the hope that most won’t.

This is exactly what I did. I submitted the DE-4 form to slash my additional state tax withholding to zero and added the corresponding allowances as provided by the withholding guidelines. This will bring me very close to the 90%-mark for the amount of taxes to be withheld without paying an under-withholding penalty come April 15, 2010.

If you are in a situation to already receive a refund next year, take some time to update your withholding by completing the DE-4 form

For all you know, as it already happened this year, when it is time to get your refund, the state might not even have the money to pay you and you will get an IOU instead. I would rather owe the state money than the other way round.

Additional links



[3] Sign the petition to repeal this additional withholding — No to Sacramento!