Avoiding taxes on fund dividends: trick

[LOL!]

I am mulling over an idea expressed on Bogleheads to convert dividends to capital gains that are then offset by carryover losses. This reduces taxable income.

Let's see if I can explain it correctly.

First, one has to have carryover losses.
Second, one sells shares that are about to pay a big dividend (say near year-end) at with a capital gain. That would be before the ex-Dividend date.
Third, the cap gain includes the effect of still having the upcoming dividend embedded in the share price, but since your realized gain will be offset by carryover losses, you have no income from this.
Fourth, you buy the shares back after it goes ex-Dividend.

I'm just wondering if this is worth it. It does seem that it is more worth it for shares that you have held short-term with only a slight gain in order to avoid taxes on dividends.

 

[GrayHare]

Hmm, sort of a reverse wash sale. Never tried it but sounds like it works, though some funds limit trading frequency. Whether it's worth the effort probably depends on the relative dollar volume you have in the fund.

With cap gains tax rates possibly rising for 2013, I'd rather save the losses until then.

 

[pb4uski]

I would think that you would have to have a huge position (ie; a huge dividend) to make this worth the effort.

 

[pb4uski]

With cap gains tax rates possibly rising for 2013, I'd rather save the losses until then.

But if you were in the 15% bracket your cap gains would be tax-free this year so that would be a situation that makes it worthwhile.

 

[GrayHare]

But if you were in the 15% bracket your cap gains would be tax-free this year so that would be a situation that makes it worthwhile.

In that situation, cap gains this year don't first cancel loss carryovers from prior years? If so, I agree.

 

[packrat44]

The process appears to be without fault. However, the avoided/converted dividends would have to be high in order to be worth the effort. Then again, you might just want to do it because you can.

 

[marko]

Would this work/make more sense if the dividend tax rate goes up next year?

 

[LOL!]

For this to make sense one would need to have substantial dividends and the desire to avoid bumping themselves into a higher tax bracket. One situation where this might occur is if one has recently done a lump-sum investment into a few taxable mutual funds. Maybe one received an inheritance?

For folks with large taxable accounts, it is not a problem to have substantial dividends and substantial carryover losses. But to avoid the dividends, one would have to sell a substantial number of shares which might have significant cap gains. Those gains, when realized, would use up lots of beneficial carryover losses that are best saved for the future I would think.

Frequent trading restrictions are not a problem for folks who use ETFs.

Anyways, thanks for responses.

 

[nun]

I tend towards the strategic rather than the tactical when it comes to tax planning......so I ignore such schemes in favor of setting things up to be in the 15% tax bracket and have a good ROTH balance. I might sell some losers to offset other gains, but that's as complicated as I get.

 

[pb4uski]

In that situation, cap gains this year don't first cancel loss carryovers from prior years? If so, I agree.

Yes, cap gains would cancel loss carryovers.

Actually the more I thought about it I don't think this trick woudl make sense for someone in the 15% bracket since both LTCG and qualified dividends are subject to a 0% tax rate.

 

[MichaelB]

I would think that you would have to have a huge position (ie; a huge dividend) to make this worth the effort.

Or a number of moderately sized investments, all with upcoming dividends.

If it is an active fund some of the distribution may be STCG and it may make sense to sell before the distribution date to avoid the ordinary income. I recall doing that more than once, although it is much less of an issue with so many passive index funds.

 

[kaneohe]

To me, this has some similarities to the investing a windfall question:
do you invest it gradually to eliminate jumping in at the wrong moment and getting killed or do it all at once because there is a long term upward bias in the market that is in your favor.

While I can understand the latter argument, my gut tells me that in order to get the odds stacked in your favor, you need to be doing it multiple times over the long term. However, the definition of windfall is different from that.

In the dividend question, assume you have a fund paying a 1% dividend quarterly (4%/yr). That means each quarter, you are seeking a 1% dividend signal amidst the market noise, which I would assume is much large than that. I could imagine that you might capture that 1% signal by having the sell #1 and subsequent buy #2 close in time. However the gains (e.g. sell #2 less buy #2) are from events separated in time and dominated? by the market noise. In the long term I can see the statistics being in your favor but I can easily see the market dynamics going against you in the short term, getting discouraged, and then not getting the benefit of the statistical odds because you quit before the long term arrived.

 

[LOL!]

I could imagine that you might capture that 1% signal by having the sell #1 and subsequent buy #2 close in time. However the gains (e.g. sell #2 less buy #2) are from events separated in time and dominated? by the market noise. In the long term I can see the statistics being in your favor but I can easily see the market dynamics going against you in the short term, getting discouraged, and then not getting the benefit of the statistical odds because you quit before the long term arrived.

I can see selling and buying at the same time much like a tax-loss harvesting move. One would sell what you got, but buy a similar, even identical, fund with a different dividend date. If using mutual funds, one could just do the exchange with the right broker.

 

[kaneohe]

I guess another way to say it is: in a down market your dividends each quarter will be buried by the market loss so you won't see any net gains. If you don't really believe in this technique and quit after a few yrs, you will have been a short term dollar cost averager who didn't run the race long enough to turn the odds in your favor. I think it would actually work if you did it long enough to average out the market cycles but the more important thing is whether you believe and whether you will actually do it for the long term.