If you use publicly traded options to lower the risk of owning stocks, the dividends you collect may not be taxed at the new 15 percent tax rate. To qualify for the dividend rate, you are expected to take on some investment risk. Thus, if you protect your holdings by buying puts, which can give you the right to sell a stock at a set price in the future, you’ve controlled your downside risk so dividends collected while the option is in place will be taxed at ordinary tax rates, up to 35 percent.
Another way to seek downside protection is 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 (“strike”) price during a set time.
To qualify for the favorable tax rate on dividends, you must use the option closest to your purchase price. Thus, if you bought General Motors at $37, you could sell calls with a $35 strike price and pay only 15 percent on your GM dividends. If you sell calls for $32.50, you’ll pocket a fatter call premium and cut your downside risk. In the latter case, you’ll pay ordinary income tax on your GM dividends.
No matter which strike price you use, the option must be in effect for more than 30 days if you want to get the lower tax rate.
