How to Model Qualified Dividends
TL;DR PRC appears to be treating Regular Investment Account qualified dividends taxed at the preferred LTCG rate as realized capital gains. Qualified dividends are reducing Capital Loss Carryover to zero before even the first withdrawal. This is not how the tax code works, is it? What am I missing?
My portfolio drawdown strategy is to spend all dividends thrown off by my Taxable “Regular Investment Account” as they are distributed then secondarily withdraw any additionally needed funds from Tax-Deferred. From separate posts we have established that 1) PRC requires reinvestment of Taxable dividends and 2) does not allow Scheduled Withdrawals from Taxable. In effect, I cannot directly access my primary source of retirement funding without setting “Regular” as the first account in the Withdrawal Order under Financial Assets > Management. That’s not my actual real-world practice nor preference, but so be it. I can still use PRC for rough modelling, just not for my actual plan. Alternately, on the Income page, I could define a custom Other Income Stream for “Ordinary Dividends” (Taxation "Regular Income") and another one for “Qualified Dividends” (Taxation "Capital Gains"), specifying the dividend dollar amount I expect to receive each year, along with an annual growth percentage. Then, since I am modelling my own taxable growth explicitly via Other Income Streams, on the Financial Assets > Asset Class Taxation page I can specify 0% for “Growth taxed as simple interest”, 0% for “Growth Taxed Annually as LTCG”, and 100% for “Growth Taxed as LTCG When Withdrawn”.
I am unable to model either of these straightforward approaches in PRC with the expected outcome and have to believe I am missing something obvious. The crux of my difficulty lies with having a rather large Capital Loss Carryover that I am leaning on for a period of tax-free income from my Taxable account, with the carryover losses offsetting all realized, otherwise-taxable capital gains until exhausted.
My frame of understanding…. Taxable assets are taxed on: 1) Annual Earnings and 2) Withdrawals, i.e. Sales. Earnings can be taxed at either the ordinary income rate (interest, non-qualified dividends, and short-term capital gains generated within the asset, not by a sale) or at the preferred LTCG rate (qualified dividends and long-term capital gains generated within the asset, not by a sale). When the investment is sold, it is taxed either as a short-term capital gain/loss (asset held < 1 year) at the ordinary income rate or as a long-term capital gain/loss (asset held > 1 year) at the preferred LTCG rate. It seems to me - and I offer this meekly and with expectation of embarrassment at overlooking something simple - that PRC is conflating the taxation of Earnings (which might happen to be taxed at the preferred LTCG rate) and Sales (which are actual LTCG gains). Qualified dividend growth is TAXED at the preferred LTCG rate but does NOT constitute a long-term capital gain; there has been no sale; there has been no realized gain. A true gain is only realized when the asset is SOLD. Actual LT gains (and losses) directly impact intrinsic portfolio value as losses can offset gains, with large enough harvested losses providing tax-free income from a Taxable account for years, or indefinitely. Qualified dividends taxed at the LTCG rate have no impact beyond a single tax year. (Again, all as I understand it.)
It appears PRC is treating qualified dividends TAXED at the LTCG preferred rate and actual long-term gains REALIZED upon withdrawal and taxed at the LTCG preferred rate as the same thing. On the Financial Assets > Asset Class Taxation page, if I specify a percentage in the “Growth Taxed Annually as LTCG” to model my qualified dividends taxed at the preferred LTCG rate, the calculated growth reduces Tabular Projections > AGI Detail > Residual Capital Loss Carryover commensurate with the calculated dividend growth. I don’t believe Form 1040 Schedule D does this. If I take the second approach above and model the qualified dividend stream as an Income > Other Income Stream with Taxation "Capital Gains", same thing. PRC interprets this as a REALIZED gain also and reduces my Capital Loss Carryover, instead of just TAXING the dividend at the LTCG rate. When I set up my model to withdraw from Tax-Deferred first and let Taxable grow undisturbed (i.e. no withdrawals/sales/gains whatsoever), I see my largish Capital Loss Carryover disappear in just a few years due solely to modelling my qualified dividends as "Growth Taxed Annually as LTCG”. The prospect of a tax-free income stream from the Regular Investment Account goes… poof. Before I’ve sold a thing. Should this be happening? (I do realize a non-zero Capital Loss Carryover will be reduced annually, at a minimum, by the $3,000 offset against ordinary taxable income, even in years with no withdrawals/sales.)
Short of PRC allowing Taxable dividends to flow straight into the Cash account (at the very top of my Christmas wish list for Santa Matthews!), do we need a mechanism to TAX growth at the LTCG rate without REALIZING LTCGs when no sale has actually been made? Is that capability already available in PRC? Modelling qualified earnings growth independently from realizing actual capital gains can make a material difference in portfolio longevity, particularly when a Capital Loss Carryover is in play.
I think I’ve identified two errors in the PRC implementation that explain what you’re reporting here:
- The Capital Loss Carryover balance is being computed incorrectly (just a logic error in the formula) and is causing the carryover balance to be depleted too quickly.
- PRC is indeed applying the Capital Loss Carryover balance to offset the qualified dividends, and shouldn’t be.
I have fixes for these problems undergoing testing right now and plan to get a new release out in the next few days.
Two other notes:
1) If you elect to model dividends via the Other Income method (on the Income page), you need to make sure that you reduce the ROR being modeled via the Financial Assets pages to eliminate the contribution of the dividends, else you'll be exaggerating your income.
2) I think Santa Matthews is going to come through for you: I'm currently in the process of designing the capability to let taxable dividends flow straight into the cash account rather than being reinvested in the 2022 model of PRC Gold. It's possible that I'll encounter an issue that makes me change my mind but I think it's going to work out.
Wow, this is some great news! I was pretty certain I was overlooking something or configuring something incorrectly. I’m never entirely confident in how I understand and interpret taxation issues. I’m too cheap to hire a tax expert so I read and research on my own, muddling through as best I can. (I also invest in world-class Personal Finance Model software! 😉) But I’m glad my questioning led to identifying the issues with handling of Capital Loss Carryover. Tweaking that will just make PRC all the better. And thanks for pointing out the need to adjust ROR downward if I model my dividend stream as an Other Income Stream. I had completely missed that.
I’ll alert the family that they might not have to worry about getting me anything for Christmas this year. Santa Matthews has got me covered! It really would be wonderful if you can work through the issues to make reinvestment of taxable dividends optional and let them flow into spendable income instead. I’ve noted a couple of others who have posted with the same approach. I wouldn’t be surprised if there are many more of us who follow this strategy, hopefully making this enhancement serve a much larger audience.
I am astounded at your devotion to your product, the speed at which you implement fixes and enhancements, and your overall ethos of partnership with serving your customers. It’s truly refreshing in a world of mediocre customer service, or no service at all, and much appreciated.