I have written many times before about tax-loss harvesting. Tax-loss harvesting is when you sell a security in a taxable/non-qualified/brokerage account at a loss and immediately buy something very similar to it but not, in the words of the IRS, “substantially identical” to it. Up to $3,000 a year of those losses can be deducted from your ordinary income and unlimited amounts can be used to offset both short and long-term capital gains from fund distributions and selling appreciated shares.
If you combine tax-loss harvesting with the step-up in basis at death and/or the contribution of appreciated shares to charity, it can be a very powerful technique that allows you to invest VERY tax-efficiently in a taxable account. You can also give appreciated shares to someone in a lower tax bracket and let them sell them, just beware of the federal and state estate/gift tax exemptions (up to $15K per person per year doesn't count toward the $11.4M exemption on the federal side, but some states have much lower limits).
Don't Reinvest Dividends in Taxable
The Wash Sale
However, sometimes people get so excited about tax-loss harvesting that they start doing it very rapidly and run into some problems.
The most common problem is doing a “wash sale.” This occurs when you buy an investment within 30 days before or after the time you sell it. While you are allowed to do that, doing so is a “wash sale” and you cannot now claim that loss on your taxes. The brokerage firms like Vanguard, Fidelity, Schwab, and eTrade are very good at keeping track of this stuff so long as you are doing all of your buying and selling at their brokerage/mutual fund firm. If you have multiple accounts at multiple firms, they won't be able to help you and you'll need to keep track of it yourself–the rules still apply.
In fact, the rules even apply if you sell one fund in your taxable account and buy it within 30 days before or after the sale in your IRA. Some have even speculated that this “IRA Rule” applies to your 401(k)s. It seems likely to definitely apply to your individual 401(k), but whether it applies to an employer's 401(k) is a little less clear. The most conservative avoid it, while the more cavalier are well aware that neither IRAs nor 401(k)s actually report your specific investments to the IRS and spend much less time worrying about this issue.
So the biggest thing to worry about with regards to the wash sale rules is selling and buying and selling and buying too fast. For example, if you exchange from the Vanguard Total Stock Market Fund to the Vanguard 500 Index Fund (not substantially identical but still with a 0.99 correlation) and then back to the Total Stock Market Fund two weeks later, you've done a wash sale. Likewise, if you buy the Total Stock Market Fund two weeks before exchanging some other shares of the fund to the 500 index fund (although note if you also sell the TSM shares you just bought, that is not a wash sale). This is a good reason not to put a taxable investing program on autopilot with frequent purchases. Less frequent, larger purchases are much easier to keep track of for tax-loss harvesting purposes.
That's exactly what burns people when it comes to reinvesting dividends. While I reinvest all my dividends in IRAs and 401(k)s, I do not do so in a taxable account. It creates lots of tiny tax lots that can be complex to keep track of (although the brokerages do a nice job), but most importantly, it means I'm buying a fund as frequently as every month, making it very tricky to avoid wash sale rules. So my general advice is don't reinvest your dividends in taxable in any investment with potential to appreciate (obviously it's fine in a fund where all returns are paid out regularly such as a money market fund or hard money loan fund.)
Beware the 60-Day Qualified Dividend Rule
Most people who have been tax-loss harvesting for a while know all about the wash sale rules (and have likely violated them once or twice.) What they may not be aware of, however, is the 60-day rule for qualified dividends. Stock dividends (including those distributed through a mutual fund) are either qualified with the IRS or non-qualified (like bond dividends.) The idea behind qualifying some dividends and not others is to encourage long-term investment. So one of the qualified dividend rules is that you must hold the investment for at least 60 days around the ex-div date (i.e. when the dividend is paid). So perhaps 45 days before the ex-div and 15 days after. Or 10 days before and 50 days after. If you don't hold the stock or fund that long, the dividend is NOT qualified, meaning you'll pay taxes on it at your higher ordinary income tax rate instead of the lower qualified dividend rate. That could mean paying up to 20% more in taxes on those gains.
So the bottom line is don't get into the habit of frenetically harvesting losses. Not only are you more likely to end up with a wash sale, but you may turn dividends that would otherwise be qualified into non-qualified dividends.
What do you think? Have you screwed up either the wash sale rule or the 60-day rule? What happened? How do you invest tax-efficiently in a taxable account? Comment below!
FAQs
Understanding Qualified Dividends
A dividend is considered qualified if the shareholder has held a stock for more than 60 days in the 121-day period that began 60 days before the ex-dividend date. 2 The ex-dividend date is one market day before the dividend's record date.
What is the 60 day dividend rule for tax-loss harvesting? ›
The wash-sale rule is an IRS regulation that prohibits investors from using a capital loss for tax-loss harvesting if the identical security, a “substantially identical” security, or an option on such a security has been purchased within 60 days of the sale that generated the capital loss (30 days before and 30 days ...
What is the wash sale rule for white coat investors? ›
The wash-sale rule prohibits selling an investment for a loss and replacing it with the same or a "substantially identical" investment 30 days before or after the sale. If you do have a wash sale, the IRS will not allow you to write off the investment loss which could make your taxes for the year higher than you hoped.
Do I need to fill out a qualified dividends and capital gain tax worksheet? ›
When you have qualified dividends or capital gains, you do not use the tax table. Instead, you will need to use the Capital Gains Worksheet to figure your tax.
What qualifies a dividend as a qualified dividend? ›
To be a qualified dividend, the payout must be made by a U.S. company or a foreign company that trades in the U.S. or has a tax treaty with the U.S. That part is simple enough to understand.
How do you know if a dividend is qualified or nonqualified? ›
How do I know if my dividends are qualified or not? You will receive an IRS form 1099-DIV from the company or your custodian at the end of the year. Qualified dividends would be shown in Box 1b whereas ordinary dividends would be in shown in box 1a.
What time of year should I do tax-loss harvesting? ›
Many investors undertake tax-loss harvesting at the end of every tax year. The strategy involves selling stocks, mutual funds, exchange-traded funds (ETFs), and other securities carrying a loss to offset realized gains from other investments.
How long do you have to hold a stock for tax-loss harvesting? ›
However, there is no such grace period for tax-loss harvesting. You need to complete all of your harvesting before the end of the calendar year, Dec. 31. So set that egg timer and get to work.
How much can you write off with tax-loss harvesting? ›
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets. An individual taxpayer can write off up to $3,000 in net losses annually. For more advice on how to maximize your tax breaks, consider consulting a professional tax advisor.
How do you avoid the wash sale rule? ›
This method is employed as a means of lowering the investor's taxable income. To avoid triggering the wash sale rule, an investor can employ a strategy such as buying more of the stock that they'd like to sell, holding on to the new stock purchase for 31 days, and then selling it.
To avoid a wash sale, you could replace it with a different ETF (or several different ETFs) with similar but not identical assets, such as one tracking the Russell 1000 Index® (RUI). That would preserve your tax break and keep you in the market with about the same asset allocation.
Do day traders need to worry about the wash sale rule? ›
Day traders, especially pattern day traders—those that execute more than four day trades over a five-day period in a margin account—may encounter wash sales regularly. The wash sale rule still applies to these traders.
How do you avoid tax on qualified dividends? ›
You may be able to avoid all income taxes on dividends if your income is low enough to qualify for zero capital gains if you invest in a Roth retirement account or buy dividend stocks in a tax-advantaged education account.
Do I pay taxes on qualified dividends or ordinary dividends? ›
Whereas ordinary dividends are taxable as ordinary income, qualified dividends that meet certain requirements are taxed at lower capital gain rates. The payer of the dividend is required to correctly identify each type and amount of dividend for you when reporting them on your Form 1099-DIV for tax purposes.
Do qualified dividends have to be reported? ›
Qualified dividends are reported on Form 1099-DIV in line 1b or column 1b. However, not all dividends reported on those lines may have met the holding period requirement. Those non-qualified dividends, as well as other ordinary dividends, may be taxed at your ordinary income tax rate, which can be as high as 37%.
What is the 61 day dividend rule? ›
To qualify for the lower tax rates, the taxpayer must now hold the dividend-paying stock for at least 61 days during the 121-day period (instead of the current 120-day period) beginning 60 days before the ex-dividend date – the first date that the buyer will not be entitled to receive that dividend.
How long does it take to own a stock to be a qualified dividend? ›
You must have held those shares of stock unhedged for at least 61 days out of the 121-day period that began 60 days before the ex-dividend date. For certain preferred stock, the security must be held for 91 days out of the 181-day period beginning 90 days before the ex-dividend date.
What is the 45 day rule for dividends? ›
The 45 day rule (sometimes called dividend stripping) requires shareholders to have held the shares 'at risk' for at least 45 days (plus the purchase day and sale day) in order to be eligible to claim franking credits in their tax returns.
