Are Puts and Calls Hiking Your Taxes?

If you use publicly traded options to lower the risk of owning stocks, don't assume that any dividend you collect will qualify for the lower 15% maximum tax rate on dividends. With some hedging strategies, you could end up owing as much as 35% on payouts.

Although it's not stated explicitly in the tax code, to qualify for the dividend rate, you are expected to take on some investment risk, tax experts say. If you protect your holdings by buying put options, which can give you the right to sell a stock at a slightly lower price in the future, you've eliminated most of your downside risk, and dividends collected while the option is in place will be taxed at higher income-tax rates. "The idea is that the government doesn't want you to earn a risk-free dividend," says Michael Schwartz, chief options strategist at Oppenheimer, a brokerage firm in New York.

Many people seek some downside protection by selling call options on their stocks. (When you sell a call option, you've given the buyer the right to purchase your stock at a set price, the strike price, for a predetermined amount of time, say, three months.) The cash earned on those option sales can offset some losses if the stock heads south.

But only some call options allow you to qualify for the favorable tax dividend. Robert Gordon, president of Twenty-First Securities, says the strike price on the call options you sell can't be more than a few dollars lower than the price that you paid for the stock. Specifically, the law says that if the strike price is below what you paid for the stock, you must use the option closest to your purchase price. (Typically, strike prices are $2.50 apart.) So if you bought General Motors at $37, you could sell calls with a $35 strike price but not $32.50. Whatever strike price you use, the option must be in effect for more than 30 days. With this strategy, you've made some additional money on the options transaction, but you're still exposed to a lot of downside risk. And to get the better tax rate, that's what the IRS wants to see.

For more details, see Twenty-First Securities' Web site,

By Susan Scherreik

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