question about the consequence of reinvesting dividends

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Justinbc6
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question about the consequence of reinvesting dividends

Post by Justinbc6 » Mon Mar 03, 2014 8:18 pm

I've looked through the wiki and searched the web and I can't find the answer to my question.

If I reinvest dividends into my stock fund for years (long enough for my INITIAL investment to qualify as long term), and then sell some shares using the average cost basis method, will the sell be considered a short term gain?

Lets assume that the amount I sell is small enough that if I chose FIFO, I could have chosen only shares that I had held for the long term.

Or, lets say I had owned a fund for several years and had reinvested dividends the entire time (up to the day that I sold), then sold all my holdings in the fund. would I pay short term gains on the entire sell, or just on the shares bought with the reinvested dividends. Again, lets assume that I use Average cost method.


I realize this is probably common knowledge, but I cant find it anywhere.

livesoft
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Re: question about the consequence of reinvesting dividends

Post by livesoft » Mon Mar 03, 2014 8:26 pm

If using FIFO, then as long as the number of shares you sell were purchased more than a year ago, then they would be considered long-term.

Reinvesting dividends is just another name for "buying more shares with the dividends the fund paid me." The "more shares" you end up "buying" are still bought on specific dates, so they will be short-term until a year has passed at which point they will be long-term shares.
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Re: question about the consequence of reinvesting dividends

Post by pjstack » Mon Mar 03, 2014 8:42 pm

Justinbc6 wrote: Or, lets say I had owned a fund for several years and had reinvested dividends the entire time (up to the day that I sold), then sold all my holdings in the fund. would I pay short term gains on the entire sell, or just on the shares bought with the reinvested dividends. Again, lets assume that I use Average cost method.
No, you will not pay short term gain on ALL the funds, just on the shares that were bought (via dividends or other purchases) within the last year. The older shares (older than one year) will be long term capital gains.
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Justinbc6
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Re: question about the consequence of reinvesting dividends

Post by Justinbc6 » Mon Mar 03, 2014 9:32 pm

OK thanks. I though that maybe my recently reinvested dividends would cause all my holdings in that fund to be "short term".

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Re: question about the consequence of reinvesting dividends

Post by grabiner » Mon Mar 03, 2014 9:53 pm

Justinbc6 wrote:I've looked through the wiki and searched the web and I can't find the answer to my question.

If I reinvest dividends into my stock fund for years (long enough for my INITIAL investment to qualify as long term), and then sell some shares using the average cost basis method, will the sell be considered a short term gain?
If you use average-cost basis, shares are still sold first-in-first-out, so your gains (or losses) will be long-term until you have run out of long-term shares.
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Re: question about the consequence of reinvesting dividends

Post by Clever_Username » Mon Mar 03, 2014 9:56 pm

What if you sold some of your portion of the fund, but not all? Would it be a long-term or short-term gain?
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Re: question about the consequence of reinvesting dividends

Post by grabiner » Mon Mar 03, 2014 10:21 pm

Clever_Username wrote:What if you sold some of your portion of the fund, but not all? Would it be a long-term or short-term gain?
Since average-cost basis sells shares as FIFO, a partial sale would be a long-term gain (or loss) unless it exceeds the number of long-term shares. With specific identification, you would have the choice of which shares to sell, but each lot has its own basis; if the highest-cost lot is a short-term lot, you have to pay short-term gains if you sell from that lot.
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Re: question about the consequence of reinvesting dividends

Post by livesoft » Mon Mar 03, 2014 10:24 pm

… unless one sells at a loss. :)
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Re: question about the consequence of reinvesting dividends

Post by Clever_Username » Tue Mar 04, 2014 1:06 am

grabiner wrote:
Clever_Username wrote:What if you sold some of your portion of the fund, but not all? Would it be a long-term or short-term gain?
Since average-cost basis sells shares as FIFO, a partial sale would be a long-term gain (or loss) unless it exceeds the number of long-term shares. With specific identification, you would have the choice of which shares to sell, but each lot has its own basis; if the highest-cost lot is a short-term lot, you have to pay short-term gains if you sell from that lot.
Interesting; I don't think I had known that. Thanks!

I don't have a particular desire to sell anything in my taxable for quite some time (well over a year; not for well over a decade for the stock funds), and I do plan on buying somewhat regularly. If I switch from average (where I am now) to specific identification, do all the existing ones become one average specific identifier, or do I need to open a new fund?

(I already take dividends into the bank, and combine them with other new money to make new purchases, so that isn't an issue in having a lot of tiny tax lots, other than that I'm contributing to taxable most months already)

Thanks again!
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Re: question about the consequence of reinvesting dividends

Post by larryswedroe » Tue Mar 04, 2014 8:57 am

Should NEVER use the average cost basis, should use individual lot basis to allow for the most tax efficient management
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Re: question about the consequence of reinvesting dividends

Post by sscritic » Tue Mar 04, 2014 9:28 am

There are three issues that get mixed together.

When you sell shares, you tell the IRS
1) which shares you sold
2) the basis of the shares you sold
3) how long you held the shares

Actually, 3 is not necessary if you answered question 1, so let's remove it.

There are two issues that get mixed together. When you sell shares, you tell the IRS
1) which shares you sold
2) the basis of the shares you sold

The terms average basis, FIFO, and specific identification are short hand notations for two part answers to the two questions. In reverse order,

specific identification actually means I sold the shares I say I sold using cost basis, which could be called specific identification - cost basis.
FIFO actually means I sold my oldest shares using cost basis, which could be called FIFO - cost basis.
average basis* actually means I sold my oldest shares using average basis, which could be called FIFO - average basis (or average basis - FIFO, reversing the questions).

[I have left out adjusted or other basis, for example if you switch from average basis to cost basis (either kind)]

In particular, when you use average basis - FIFO (FIFO - average basis) you sell the oldest shares first. If you have more long-term shares than the number of shares you sell, all of the sold shares are long term.
In the case of the sale or transfer of shares of stock to which the average basis method election applies, shares sold or transferred are deemed to be the shares first acquired. Thus, the first shares sold or transferred are those with a holding period of more than 1 year (long-term shares) to the extent that the account contains long-term shares. If the number of shares sold or transferred exceeds the number of long-term shares in the account, the excess shares sold or transferred are deemed to be shares with a holding period of 1 year or less (short-term shares).
26 CFR 1.1012-1

This means you can't use average basis without selling your oldest shares; that's the regulation.

* The IRS very rarely uses average cost basis, using average basis or average basis method in the regulations and most publications.

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Re: question about the consequence of reinvesting dividends

Post by Clever_Username » Tue Mar 04, 2014 11:35 am

First, thanks for the very detailed response.

If I understood it correctly, I can switch from average to specific ID for future purchases, and keep the shares I have in taxable -- I don't have to sell them and re-purchase them. It's just that a subset of them are going to be treated as average cost, and any subsequent purchases will be specifically identifiable. Anything from the shares purchased while I was doing average cost will be treated as FIFO.
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Re: question about the consequence of reinvesting dividends

Post by sscritic » Tue Mar 04, 2014 11:59 am

Clever_Username wrote:First, thanks for the very detailed response.

If I understood it correctly, I can switch from average to specific ID for future purchases, and keep the shares I have in taxable -- I don't have to sell them and re-purchase them. It's just that a subset of them are going to be treated as average cost, and any subsequent purchases will be specifically identifiable. Anything from the shares purchased while I was doing average cost will be treated as FIFO.
Actually, it is more complicated than that, but that is part of the advanced course. You certainly don't have to sell and repurchase to start using specific id - cost basis on shares purchased in the future after you tell Vanguard you want to use specific id.

The more complicated part is when you want to sell the old shares. My understanding is that you have to tell Vanguard to sell the old shares that were previously averaged by specifically telling them to do so, i.e., you have to specifically identify the old shares you want to sell, but the basis is not the cost but the previous average. Using the two part notation to clarify the different roles of which shares and basis of those shares, you will be using specific id - previously averaged basis, not specific id - cost basis.

That's the method I left out of my first post. The IRS asks for cost or other basis. This is an "other basis," just as inherited shares have an "other basis." Shares that were washed during a wash sale also have an "other basis." Cost is almost irrelevant; the real issue is basis, cost or not.

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Re: question about the consequence of reinvesting dividends

Post by Clever_Username » Tue Mar 04, 2014 12:05 pm

Sounds good. I'll change the preference within my Vanguard account later today. I'll deal with the "how to sell the shares that were purchased as average cost" headache when I'm ready to sell.


Thanks again!
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Re: question about the consequence of reinvesting dividends

Post by sscritic » Tue Mar 04, 2014 12:11 pm

I believe that if you just call up and tell Vanguard you want to sell using average basis after switching to specific id that they will take that as a change from specific id to average basis and average in all the new shares that you thought were going to be specific id when they sell your old shares first-come-first-served. Thus, I suggest that you be very clear that you are identifying the old previously averaged shares as the ones you want to sell and that you are not changing your basis method on the newer shares.

P.S. One other point. The average basis of your uncovered shares is computed separately from the average basis of your covered shares. This is because Vanguard, like most firms, did not elect to use the single account method. Your uncovered shares are treated as one account, and your covered shares are treated as another account, just as if they were held at another firm.

P.P.S. The thing I find amusing is that while Vanguard does disclose this, they then state they will violate the regulations by selling your uncovered shares first if you use average basis. This is Vanguard trying to have its cake and eat it too. If the accounts are separate, selling average basis from your uncovered shares account should sell the oldest of your uncovered shares, but selling average basis from your covered shares account should sell the oldest of your covered shares, not any of your uncovered shares.

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Re: question about the consequence of reinvesting dividends

Post by FillorKill » Tue Mar 04, 2014 12:13 pm

Maybe I don't understand one of the more nuanced points being made in this thread but FWIW: Last week I set the cost basis on a taxable VG account (not mine) to spec id where no prior election had been made. It took a day or two but the result is that all lots in that account, going back to 01 Jan 2012 are 'covered' and the lots are all there identified by transaction as any other spec id transaction appears. All of the holdings 2011 and prior are lumped into the 'noncovered' category. I'm not sure if this would have played-out differently if the prior election for average basis had been made and then a change to spec id were initiated - I've not done that.

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Re: question about the consequence of reinvesting dividends

Post by sscritic » Tue Mar 04, 2014 12:29 pm

BBL wrote:Maybe I don't understand one of the more nuanced points being made in this thread but FWIW: Last week I set the cost basis on a taxable VG account (not mine) to spec id where no prior election had been made. It took a day or two but the result is that all lots in that account, going back to 01 Jan 2012 are 'covered' and the lots are all there identified by transaction as any other spec id transaction appears. All of the holdings 2011 and prior are lumped into the 'noncovered' category. I'm not sure if this would have played-out differently if the prior election for average basis had been made and then a change to spec id were initiated - I've not done that.
Yes, default vs election is a nuanced point.* There is a one-year limit to elect away from the default, but the firms can extend the period. Vanguard has chosen to extend it indefinitely. A prior sale at the default of average basis would have locked things in.

* The original regs made the distinction in a way that raised a lot of objections about different treatments of what were essentially identical situations. As I understand it, the regs haven't been rewritten, but the IRS has said to ignore the regs in this one situation. I may be wrong, and the regs have been rewritten. I could look, but it is morning soap time.

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Re: question about the consequence of reinvesting dividends

Post by FillorKill » Tue Mar 04, 2014 12:32 pm

sscritic wrote: Yes, default vs election is a nuanced point.* There is a one-year limit to elect away from the default, but the firms can extend the period. Vanguard has chosen to extend it indefinitely. A prior sale at the default of average basis would have locked things in.

* The original regs made the distinction in a way that raised a lot of objections about different treatments of what were essentially identical situations. As I understand it, the regs haven't been rewritten, but the IRS has said to ignore the regs in this one situation. I may be wrong, and the regs have been rewritten. I could look, but it is morning soap time.
That is what I wanted to know. You saved me a future call to the mothership. Thank you.

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Re: question about the consequence of reinvesting dividends

Post by sscritic » Tue Mar 04, 2014 12:35 pm

BBL wrote:
sscritic wrote: Yes, default vs election is a nuanced point.* There is a one-year limit to elect away from the default, but the firms can extend the period. Vanguard has chosen to extend it indefinitely. A prior sale at the default of average basis would have locked things in.

* The original regs made the distinction in a way that raised a lot of objections about different treatments of what were essentially identical situations. As I understand it, the regs haven't been rewritten, but the IRS has said to ignore the regs in this one situation. I may be wrong, and the regs have been rewritten. I could look, but it is morning soap time.
That is what I wanted to know. You saved me a future call to the mothership. Thank you.
Now I recall the original issue. Is an election away from the default a change of method? The rules are tricky.

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Re: question about the consequence of reinvesting dividends

Post by Toons » Tue Mar 04, 2014 12:38 pm

Example:
I Have purchased and reinvested dividends in Vanguard Short Term investment Grade for 6 years.
I sold "some" shares 3 weeks ago.
The shares I sold were those that were purchased ,along with reinvested shares , 6 years ago
All shares treated as long term gains,held over a year,First In First Out,average cost basis
Keep It Simple :happy
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Re: question about the consequence of reinvesting dividends

Post by Clever_Username » Tue Mar 04, 2014 12:55 pm

sscritic wrote:P.S. One other point. The average basis of your uncovered shares is computed separately from the average basis of your covered shares. This is because Vanguard, like most firms, did not elect to use the single account method. Your uncovered shares are treated as one account, and your covered shares are treated as another account, just as if they were held at another firm.
Thanks for the warnings. All of my shares are covered, I believe -- I got out of some bad funds in 2012, and that was when I first purchased taxable funds at Vanguard. For some reason, my t-IRA has uncovered shares, but I don't believe that matters.
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