Anyone that has investment of any kind realizes that you are taxed on investments in several ways. In this chapter we’re going to focus on stocks. We’ll cover taxes in general in a separate section later in the book. Taxes are a vital element in having a successful retirement plan.
Dividends: Stock dividends are taxed in one of two ways. Dividends from an unqualified stock are taxed as ordinary income, meaning you owe a tax on the dividend based on your income tax rate. Qualified stocks are taxed at the capital gains rate, which is almost always lower. Your dividend is qualified if you hold your stock investment for more than 60 days during the 121-day period that begins 60 days prior to the ex-dividend date — which is the day after a corporation’s board declares a dividend payment to shareholders.
Gain: Any increase in the value of a stock may be taxed as capital gain when you sell the stock. If you’ve held an investment for less than a year you pay short term capital gains on it, which is usually 10 to 20 percent more. People in the lowest tax brackets usually don’t have to pay any tax on long-term capital gains, so the difference between short and long term can be a tax at your highest rate or zero tax.
A high turnover rate for a mutual fund means many of the stocks within that fund will be bought and sold within the period of short term capital gains. The fund manager certainly doesn’t take your specific tax situation into account when they are deciding to buy or sell, but their decisions can have a big effect on your taxes. Of course this is moot in non-taxable savings accounts like IRAs and 401K, though the overall change in the value of the funds will result in taxes when the money is withdrawn. If your funds have done well, that’s a tax you shouldn’t mind paying since your investments have grown tax-free over the period they were held.
In taxable accounts, the turnover results in a yearly tax bill for gains that you may not have benefitted from. One more good reason to use tax-efficient funds like index funds, where turnover is generally low. Each mutual fund you own delivers a yearly distribution of gains, and you are required to pay taxes on those distributions whether they are paid in cash or reinvested in the fund. The distributions are often characterized as a benefit to the shareholder, but since the value of the shares declines more or less in step with the distributions, the taxes on the distribution tends to dilute your ownership –even though you might have more shares after reinvestment. If you take your money out of one mutual fund and move it to another it may not feel like you received your money back and then reinvested it, but Uncle Sam treats it like any other sales and purchase, so you must report and pay taxes on any gains.
In taxable accounts, you can use the losses to lower your tax bill. The simple approach to this is that when you cash out of a set of funds the capital losses of one may offset some or all capital gains of another. There’s a more complex strategy for managing your investments without cashing out called tax loss harvesting.
Here’s how tax loss harvesting works. You’ve invested $20,000 in a fund in a taxable account but the fund sucked and it’s now worth $10,000. You have faith for some reason that the fund will recover, so you want to keep holding it. But you want to “harvest” those losses, so you sell the fund, and then buy it back 31 days later to avoid the wash sale rule. Or you’d buy a similar investment that skirted the rule. You now have a $10,000 capital loss that you can use to offset a capital gain.
Understand that in the long term you haven’t gained anything. Your basis in the fund is now $10,000 less. If it returns to $20,000 and you sell it, you owe capital gains on $10,000. Do it all wrong and that could be short-term capital gains, which means you will pay more taxes. Do it right and your tax bracket may have changed. If it’s downward, then you pay less in taxes, but it could be upward, which means you pay more. In any case, you don’t avoid the capital gains from Tax Loss Harvesting unless you die, in which case it may be excluded because of a stepped-up basis. A weird element of estate taxation, but what else is new.
So why do it? First, you can consider it an interest-free loan from Uncle Sam. The loss can be offset against any other capital gain, and you can even use $3,000 of it ($1500 is married filing separately) to offset ordinary income each year. The remainder is carried forward into subsequent years. There’s more to this–if you’re paying AMT (Alternative Minimum Tax) you won’t get a deduction, but we’ll cover that later.
It’s also more likely that the capital gains resulting from the lower basis will come due some time in the future when your income is proportionally less and your tax bracket will be lower. Assuming the tax code remains the way it currently is (not a safe assumption) you will pay at a lower rate.
The most important rule in implementing tax loss harvesting is not to let the tail wag the dog. You shouldn’t be making investment choices on the basis of tax loss harvesting, rather, you should look for opportunities to optimize tax strategy when you are making prudent changes.