Monday, August 17, 2015

Tax Loss Harvesting for Dividend Investors

As an investor my goal is to attain financial independence using my dividend growth strategy. As a dividend investor, my goal is to generate enough dividend income to pay for my expenses in retirement.

In order to achieve this goal, I have spent several years selecting quality dividend paying stocks. However, as I gain more knowledge, I also try to pick new tricks that would help me on my journey.

One of those tricks is tax-loss harvesting. Tax loss harvesting is selling securities at a loss in order to offset a capital gains tax liability. Tax loss harvesting is typically used to limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates than long-term capital gains.

The benefit of tax-loss harvesting is that I will reduce my taxable income, which will reduce taxes I pay and results in more money available for me to allocate.

A taxpayer can use that loss to offset against other short-term or long-term capital gains. If there are no capital gains however for the year, then the taxpayer can reduce their income by $3,000 at most of a given year. If their capital loss exceeds $3,000, they can use it on future gains they incurred. If that taxpayer never earns another dime in capital gains, they can go on to reduce their income by $3,000/year, until their capital loss is exhausted. Depending on your marginal tax rates, triggering this $3,000 loss could result in a substantial tax benefit. I am in the 25% tax bracket, which means that $1,000 in capital losses translates into a reduction of my tax liability by $250. This of course assumes I earned no capital gains. However this is not a problem for me, since I am quick to book my losses, but I let my gains compound for years.

The downside is that you have to be careful not to trip the wash sale rules. In addition, it might be helpful to determine if the cost of executing a tax loss harvest is worth it.

The wash sale period for any sale at a loss consists of 61 days: the day of the sale, the 30 days before the sale and the 30 days after the sale.

I have recently started a strategy to harvest capital losses on companies I own, and would like to continue owning. So in essence, I am trying to legally minimize taxes on companies I have a temporary loss, while also continuing to own the shares. My threshold for doing a tax-loss harvest is an unrealized loss of $1,000. This is because there is a cost to pursue this strategy, that has to exceed the benefit. In addition, I try to do tax-loss harvesting mostly on positions where I own approximately 100 shares or more.

Let’s walk through an actual example. I am using information as of Friday, August 14 2015. Let’s say I own 100 shares of ONEOK Inc (OKE) with a cost of $58 and current price of $36.28. This translates into a tax losses of $2,172.  All prices discussed are from Friday, August 14, 2015.

The way I do it is first I buy 100 additional shares of the stock. It is important to purchase these shares at least 31 calendar days prior to the expected sale of the original shares. Under current environment, this translates into selling options expiring on September 18, 2015.

Then I buy a put at or slightly below current price. In an ideal scenario, this option will be expiring sometime within the next 32 – 35 days. Let’s say I bought a $35 put expiring on September 18, 2015 at $1.55/contract. This put provides the right, but not the obligation to sell 100 shares of ONEOK Inc at $35 on September 18, 2015. The purpose of the put is to protect the additional 100 shares I just purchased.

Following this I sell a covered call in-the money for the security I already own. I sell the covered call in order to “lock in” the sale price of the original shares. In an ideal scenario, this option will be expiring sometime within the next 32 – 35 days. I plan on holding on to this stock for at least 31 days. Let’s say I sold a September 18, 2015 call at strike $35 for $2.40/contract.

Ideally, I want to avoid doing this around the ex-dividend date, because this increases the risk that the covered call be exercised earlier than my planned timeframe. ONEOK Inc will have the next ex-dividend date in October, so this is not really an issue.

I have several scenarios on what will happen on September 18, 2015.

Under the first scenario, the price of ONEOK Inc shares sell above $35/share. As a result, the put expires worthless. The covered call will be exercised, therefore locking the sale of the original 100 shares at $35. That way I realize a tax loss of $2,300 on the sale of the security. This loss is reduced by the $240 I received from selling the call but increased by the $155 I paid for the protective put. Luckily I still own the stock, since I purchased the second batch of 100 shares over a month earlier.

Under the second scenario, the price of ONEOK shares is under $35/share. As a result, the covered call expires worthless. However, the put will have an intrinsic value, that will be derived by subtracting the current market price pf the stock on September 18, 2015 from the strike price of $35. Let’s assume that the shares are selling for $34/share. This means that I can essentially sell my original shares for $34, locking my loss. The puts I bought will result in a loss of $55. If the stock sells below $33.45/share, the puts will result in a gain, though I would be able to sell the shares at a lower price.

There is a third scenario, under which the price of ONEOK shares is exactly $35 at the time of expiration on September 18, 2015. As a result, I will book a loss of $2,300 on the sale of the stock, offset by a gain of $240 on the call sold, and increased further by the $155 loss on the put I purchased.

Tax-loss harvesting is one of the reasons why stock picking is a superior strategy than indexing. There are always investments within my portfolio which will do worse than expected, even if the portfolio itself does great over time. The same is true for index portfolios - some of the companies will go up in price, while others will go down in price. It makes sense to hold shares directly, and harvesting taxable losses as they occur and the benefit outweighs the cost. As a result, the investor is better off holding on to the individual securities that comprise a portfolio, rather than hold that portfolio directly. This is probably one of the reasons why you frequently see high networth individuals holding shares directly, rather than through mutual funds. Another reason could be that it could be cheaper to purchase shares in the 500 companies in the S&P 500 directly, rather than pay an ongoing fee each year.

In conclusion, I shared a method where dividend investors can use the tax code in order to reduce their tax liabilities while still maintaining ownership of their investments. With tax-loss harvesting I can end up in a better financial position, which can further speed up my journey to financial independence. Those who never take the time to learn the tax code, and use it to their advantage, will be hundreds of thousands of dollars poorer by the time they reach the traditional retirement age. But those who do learn how to utilize the rules to their advantage, the financial independence journey would be faster to accomplish.

Full Disclosure: Long OKE

Additional Disclosure: I am not a tax professional, and this article is based on my understanding of the US tax code. Although I do my own tax planning, I advise other people to speak to a qualified tax professional about taxes.

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investors
My Retirement Strategy for Tax-Free Income
Why I Considered Tax-Advantaged Accounts for My Dividend investing
Dividends Provide a Tax-Efficient Form of Income
How to buy dividend paying stocks at a 25% discount

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