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

10 comments:

  1. Not sure I agree that owning individual stocks makes it easier to harvest tax losses...If you own an index fund with a loss you can just sell it and harvest the loss and then immediately buy a similar index fund from a different fund company without having to do all this options stuff.

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    1. Your comment shows that you have not understood this article. Let me illustrate it with a simple example.

      In 2014, the Dow Jones Industrials produced a total return of 10%, the capital return being 7.5%. Therefore, the index investor would have not been able to recognize any tax losses.

      http://dqydj.net/2014-dow-jones-industrial-average-return/
      However, 8 out of the 30 components of the index went down for the year. So if you had recognized that tax loss, your situation would have been much better than simply holding on to the index.

      http://www.cnbc.com/2014/12/30/the-2015-dogs-of-the-dow.html

      So this example proves that an investor holding individual stocks is better off than the one holding the index.

      Plus you wouldn’t pay 0.17% in annual management fees every single year on the (DIA) ETF, which on a $100,000 portfolio cost $170/year. With Interactive Brokers, my total commission cost on buying 30 companies would be something like $10 - $11.

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    2. I think I understand your article...your 2014 example is spot on, but please allow me to show an alternative example... in 2008 the DJIA went down 34% and pretty much every single stock was down. So you would have had to try and do this expensive options trading for every position in your portfolio, while an indexer could have done this in two quick trades. BTW, I'm a stock picker like you that's why I enjoy reading your site, but indexing does have its occasional advantages.

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    3. Index funds routinely harvest tax losses within the fund to minimize or eliminate capital gain distributions. You may be faced with a situation someday with no losses to harvest and the need to sell a stock with a large unrealized gain because it no longer fits your strategy (e.g. dividend is cut or eliminated). Worse, it could be a short term gain. The knife cuts both ways.

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    4. You have good questions. I might incorporate them to beef up the article if I have more time.

      Per you point about the whole index being down – technically, not every stock will be down in a given year. In 2008, not every stock went down – McDonald’s and Wal-Mart stores actually went up. So an individual stock picker was likely better off than an index investor. Options trading is not expensive - $1 for each options transaction with Interactive Brokers and 35 cents on the stock transaction is not bad.

      On your first point think about this:

      I. Which is more likely
      1) That the index goes down like it did in 2008 ( probably one in 3 or 4 years will be a down year)
      Or
      2) That one or more of the components of the index goes down in every single year (based on my review I would expect that at least a few components will be down even if the index goes up for the year)

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    5. Anonymous from 10:53AM

      The Vanguard 500 index fund does distribute capital gains, when it had them during the bull market of the 1990s. It distributed capital gains between 1994 to 1999. Check page 17:
      http://www.sec.gov/Archives/edgar/data/36405/000093247103000714/usstockindexformncsr.txt
      The reason why the S&P 500 index fund has not distributed capital gains for the past 15 years is because it has huge capital loss carryforwards from the early 2000s, which is probably when a lot of people abandoned indexing and sold out at the bottom because they were scared. Check table 3: http://www.bogleheads.org/wiki/Vanguard_500_Index_Fund_tax_distributions
      One of the reasons why holding index funds in a taxable account could be an issue, is because of the frequent portfolio churn by index funds. As a result of the churn, the index fund can distribute capital gains to you, and you have absolutely no say about that and the fact that it will render any tax planning very difficult. So yes, you are correct that holding individual stock picks provides more flexibility than indexing, when it comes to the timing of capital gains.

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  2. Couple of thoughts: 1) There is an opportunity cost to having capital tied up in purchasing an extra 100 shares of stock you have no intention of owning in the long run. 2) Why not just sell the stock and wait 30 days to repurchase it? If you're concerned that the price of the stock would rise during the interim, you could purchase a call to mitigate that risk. If the price falls further during the 30 day wait period, you would be able to buy more shares with the proceeds from the sale and increase future dividend revenue stream.

    You are incorrect about an index investor not being able to tax loss harvest. Index investors are able to sell specific share lots. You can take the proceeds from the sale of one fund and invest it simultaneously in another fund that is highly correlated to the fund you're selling as long as it has a different CUSIP number. Vanguard's 500 and Total Stock Market Funds are highly correlated for example and essentially could be used as a proxy for each other.

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    Replies
    1. 1) Actually, in the example above, I use a company I am interested in holding, but I still want to get the tax benefit as well. Please re-read the article until you get this point.

      Your comment about opportunity cost makes no logical sense – if you put $3500 more in stock for the additional shares in order to generate a tax savings of 25% times $2300 in 31 calendar days. How much is that, and what other investment can generate that return in 31 days.

      2) Yes but I have to get the timing right on the sale of the stock to recognize the loss, and the purchase of the call without triggering the wash sale rules. I can’t sell the stock and buy the call right away – I need to have a 31 day difference between those two activities in order to avoid wash sales.

      3) I didn’t say index investors cannot do tax loss harvesting. I provided s specific examples that holding individual stocks is SUPERIOR to holding an index for tax loss harvesting. Please read the article again, read the comments above.

      The IRS doesn’t want you to purchase “substantially identical” investments when you do the tax loss harvesting. The only reason you sell SPY is to get the loss, and the only reason you buy VTI is to purchase a security that delivers a very similar return to SPY. You inherently believe those are substantially identical, hence in my view, you are breaking the law. So if you sell SPY at a loss and buy VTI , what is the likelihood that an IRS audit would prohibit you taking this deduction and you would have to go to court to get the money? I am not an IRS agent, nor a lawyer, nor a financial adviser, but I see increased risk in doing what you are proposing to be doing.

      I see a lot of services that promise you excess return while they purchase what in my view are substantially identical securities. These have not been around for too long, so my view is that the IRS will challenge those at some point.

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  3. Good info regarding efficient tax management. I'd like to add another possible situation regarding the subject...

    I BOT 600 shares of CHY for $8782. It's now worth $7110. By selling, I could claim a $1672 loss on my taxes. However, over the years I've received $5191 in dividends for an overall gain of 40% on the investment.

    I didn't buy the stock to lose money but the price has gone down. I'll pay a maximum 15% tax on the dividends received but be able to claim the loss when I sell.

    Just another perspective...trying to find the silver lining.

    Thanks for you work and ideas, DGI.

    SAK

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  4. Good article. Curious why you decide to buy a put. To protect your new shares? It seems to me that selling the ATM covered call will lock in the loss. I guess I'm missing what the put provides. Thanks in advance for the clarification.

    Also, the qualified dividend rules are another reason to avoid doing this around ex-div dates.
    Thanks.
    -Z

    ReplyDelete

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