Income: Taking Dividends as Cash, vs. Selling Shares

[Telly]

I've been thinking about this situation. I thought I knew the answer to the first part, but now I'm not so sure, maybe I'm missing something.

Let me create a scenario. Two people, "A" and "B", own the same number of shares in the "Early Retirement Mutual Fund" (ERMF). ERMF is an equity fund that has a moderate/high rate of dividends. Dividends are paid quarterly.

Persons A and B have both decided to start tapping their respective ERMF funds.

Person A - Switches their dividends to be taken as cash. Capital Gains continue to be reinvested. So every quarter, Person A gets a varying amount of cash.

Person B - Has a different approach. He leaves the dividends to be reinvested. And Capital Gains continue to be reinvested. But every quarter, right after the dividends are declared then reinvested, he sells a dollar amount of shares equal to what the total dividend amount for that quarter was. That is, if the amount of dividends declared and reinvested that quarter were $5,000, he sells $5,000 worth of shares.

So Persons A and B are both withdrawing the same amount of money. They follow their respective methods quarter after quarter for many years.

Question 1) Looking at both accounts years in the future, will the value of their ERMF accounts still be equal, Person A vs. Person B?

Question 2) If I now add a little real world, and say that the above scenario had both person's ERMF accounts as Taxable accounts, is there an advantage to A vs. B's methods, as far as minimizing overall Federal income tax?
(assume there is no difference in AGI between these two people, except for any created by their respective methods of tapping ERMF).

Question 3) If I said that the scenario above was actually in IRA's, and both Persons A and B were over 59 1/2 YOA when they started this, is there any advantage to A vs. B's methods to maximize income and minimize Fed taxes?
(once again, assume there is no difference in AGI between these two people, except for any created by their respective methods of tapping ERMF).

 

[clifp]

From the way you are describing there shouldn't any difference between the income or taxes for any of the scenarios. It is possible that due to the difference of when a fund is declared Ex-dividend and the payable date that there maybe some difference, but I am general think there is no difference.

Why the question?

 

[sailor]

Just one comment - don't do automatic re-investmant in taxable account.
Both of these scenarios will be a slight accounting pain (although good software or brokerage will do it for you), but B is worse (triple amount of transactions to keep track of) so keeping up with your cost basis will be a pain. Additionally in scenario B you might want to use specific share lot valuation method (provided it's still available to you), which is even more tedious.
How about a person C, who takes both of their dividends and capital gains in cash, lets them sit in cash and uses the money for yearly re-balancing?

 

[ERD50]

From the way you are describing there shouldn't any difference between the income or taxes for any of the scenarios.

Wouldn't taxes be higher for B - divs and cap gains are taxed as they are issued, whether you 'take' them or re-invest them. So taxes the same there, but B is also selling shares and there could be a cap gain on those.

I also agree with sailor, KISS method and do not reinvest divs/gains in a taxable account. It simplifies things and gives you the flexibility to use that for rebalancing.

-ERD50

 

[Texas Proud]

Wouldn't taxes be higher for B - divs and cap gains are taxed as they are issued, whether you 'take' them or re-invest them. So taxes the same there, but B is also selling shares and there could be a cap gain on those.

I also agree with sailor, KISS method and do not reinvest divs/gains in a taxable account. It simplifies things and gives you the flexibility to use that for rebalancing.

-ERD50

YES... taxes would be higher for B unless his basis in the fund is higher than it it worth right now...

Think of it... B reinvests his dividends... but he is taxed on them as if he got them... so he is taxed like A on them... BUT, he did reinvest and then sold the same amount... so now he has a capital gain... and if you are not doing specific lots, then you have LT and ST gain....


So... answer to 1 is.... if it is not a taxable account... there is not a difference... as it is the withdrawal that makes it taxable...

2. is they are not the same... (I am throwing in another item... this is their ONLY investment).... because B has to pay more in taxes (well, he could just not buy as much and pay the extra taxes from the withdrawals, then they would be equal)...

3. No... all withdrawals from a taxable account are normal income... it does not matter what is happening inside the account... it is the distribution that matters...

 

[LOL!]

If dividends are re-invested in a taxable account, then the shares are immediate sold, then there are consequences:

You would be selling shares with FIFO probably so your long-term shares would be "used up". But those older shares might potentially be sold at a loss, but since you just purchased new shares, you have bumped up against the "wash sale" rule. If you sold those FIFO shares at a gain, then no problem.

Since you should be tax-loss harvesting all along in a taxable account, you really should not have any LT shares with losses, so the wash-sale problem would be a remote possibility. Nevertheless, why use up LT shares with their potentially lower basis? If you just took the dividends in cash, you would not have this problem.

Of course, you could do the specific share identification with your ERMF shares and sell those recently re-invested dividends, but then you have to have a broker that makes that easy.

 

[Texas Proud]

If dividends are re-invested in a taxable account, then the shares are immediate sold, then there are consequences:

You would be selling shares with FIFO probably so your long-term shares would be "used up". But those older shares might potentially be sold at a loss, but since you just purchased new shares, you have bumped up against the "wash sale" rule. If you sold those FIFO shares at a gain, then no problem.

Since you should be tax-loss harvesting all along in a taxable account, you really should not have any LT shares with losses, so the wash-sale problem would be a remote possibility. Nevertheless, why use up LT shares with their potentially lower basis? If you just took the dividends in cash, you would not have this problem.

Of course, you could do the specific share identification with your ERMF shares and sell those recently re-invested dividends, but then you have to have a broker that makes that easy.

From what I understand (and I could be wrong)... most people use what the fund tells them... and that is average cost... so he will have a part of the sale as long term and part as short term... the wash rule might not come into play if we are talking quarterly distributions... but monthly... yes...

 

[scrabbler1]

I have dividends from several different stock and bond mutual funds. Some of the bond funds are tax-exempt, others are taxable. What I do with each one depends on my objective for each, and that varies. Some I reinvest in the same fund, others I invest in another fund automatically (like an automatic account builder). Others I take as cash to cover my regular ER expenses.

I use FIFO for any straight redemptions I make, which are very few (either via check, electronic redemption, or exchange) and far between. I have spreadsheets for each fund so I can keep track of which FIFO shares I am selling. Just keeping the number of redemptions low makes my calculations pretty easy, even at tax time.

 

[clifp]

I don't think it makes a difference in case B, unless you use average share accounting and have a gain.

Say you have 10,000 shares at $10.00/share of the fund. It pays out .05 every quarter. On June 27 it goes ex-dividend and the NAV of the fund drops $10.00 to $9.95, the $500 in dividend buys 50.25 shares on July 1. On July 2 you sell 50.25 shares at $9.95 you have no capital gain or loss, but the $500 in dividend income is taxed.

 

[Texas Proud]

I don't think it makes a difference in case B, unless you use average share accounting and have a gain.

Say you have 10,000 shares at $10.00/share of the fund. It pays out .05 every quarter. On June 27 it goes ex-dividend and the NAV of the fund drops $10.00 to $9.95, the $500 in dividend buys 50.25 shares on July 1. On July 2 you sell 50.25 shares at $9.95 you have no capital gain or loss, but the $500 in dividend income is taxed.

That is ONLY if you elected to do specific lot trading at the beginning... if you have done any other method, you can not do specific lot trading..

And there is that pesky record keeping...

It is much easier IF you need the money to have it deposited in a MM account and spend it... anything else besides that adds complications...

 

[Telly]

Thanks to all who commented and analyzed!

One night, staring into the monitor, I came up with the "Person B" alternative. I then rejected it as having the same fund value off in the future, as compared to the usual "Person A" take dividends as cash method. But then I started to wonder what the effects of the reinvest-the-dividends-but-sell-an-equal-amount-of-shares would lead to. And I had difficulty envisioning it, taxes and tax methods kept creeping in. And then there was the complexity. And even if the dividend ex-date and reinvest date were the same day, Person B would only find out what the dividend was after the markets closed and the fund company declared dividend, meaning B could not sell shares till the next market day, so there was a minimum 1 day market value change possibility each quarter.

So with your help, I have thrown it onto the great trash-heap of ideas that have no merit.

We DO have some taxable mutual funds that we are reinvesting dividends and capital gains into. I didn't see a way around this, if one wants after-tax investments. With a significant MM/CD/SB/IB buffer, though getting worked down, still has quite a bit of life in it, we don't need to spend dividends, not yet, anyway. That said, I did unexpectedly receive a 5-figure inheritance, which I have kept as separate property wrt the laws of our state. As such, to avoid co-mingling of funds which kills separate property, I have the dividends of the Moderate Allocation fund (Morningstar category, more descriptive than "balanced fund") paid to me in cash, which is put towards living expenses.

Eventually, as the buffer declines to some threshold yet to be determined, then we will change all the taxable funds to dividends as cash.

So what about rebalancing? Well, I have rebalanced when needed in my IRAs. Long-term, to keep to + 5% of target allocation will require more fixed in the IRA, as the fixed (buffer) in taxable is spent down.