Timing of transactions to reduce taxes

If you are planning to make a transaction in your taxable account, it may sometimes be worth delaying the transaction slightly in order to reduce taxes. (Do not wait a long time for the tax-optimal date; any tax saving may be lost in the cost of having the wrong portfolio for too long.) This page summarizes some of the most common issues.

Buy after distributions
If a stock fund is about to make a significant distribution, you may owe tax on that distribution if you hold the fund on the distribution day. (This does not apply to most bond funds, which pay a dividend for every day you held the fund.) Therefore, it is often worth waiting until after the distribution is made.

For example, suppose that you would like to invest $21,000 in a fund which is selling at $21 a share and will distribute $1 a share in dividends and capital gains next week. If you buy now, you will have 1,000 shares, and you will receive a $1,000 distribution. If the market does not move, the fund price will drop to $20, so you can reinvest the distribution at that price to keep a $21,000 investment; you will then have 1,050 shares with a basis of $22,000, and taxes due on the $1,000 gain. If you wait until after the distribution, you will not pay any tax, so you will have 1,050 shares with a basis of $21,000; you will not pay tax on the $1,000 basis difference until you sell.

Another factor to keep in mind is the tax rate that you will pay upon a purchased distribution and the tax rate that will be paid by deferring it and paying the tax at a later date. This factor applies to both qualified dividends  and long term capital gains distributions, both of which are currently taxed at 0% for investors in tax brackets below 25% (from 2008-2010). After 2010, qualified dividends are slated to be discontinued, with dividends being taxed at marginal tax rates (see table below). Capital gains rates are set to increase to 10% for individuals in the 15% tax bracket and 20% in higher brackets. One must also factor in the rate at which the distributions are taxed by your state of residence before determining the tax costs of timing the purchase.

If you are planning to invest in a stock index fund which pays dividends quarterly, the distribution should be small enough (likely about 0.5%, all qualified dividends) not to be a concern.

Sell for long-term gain before distributions
If you plan to sell a fund which is about to make a distribution, that distribution will reduce your capital gain, but you will pay tax on the distribution. Therefore, you want to sell before the distribution if the distribution is taxed at a higher rate than the capital gain, and after the distribution if it is taxed at a lower rate.

For example, suppose that you bought a fund for $18,000 and it is now worth $21,000, and it will distribute $1,000 in gains next week. If you sell now, you have a $3,000 capital gain; if you wait to receive the distribution before selling, and the market does not move, you will have a $1,000 taxable distribution and a $2,000 capital gain. Thus, by waiting to sell, you pay tax on $1,000 at the rate on the distribution, rather than at the capital-gains tax rate. If your gain is long-term, the capital-gains tax rate is less than the distribution tax rate (or at worst equal if the distribution is 100% long-term gains and qualified dividends), so you should sell before the distribution; if your gain is short-term, you should sell after the distribution.

Conversely, it is better to sell an international fund after a distribution of qualified dividends, because the effective tax rate is very low. You pay taxes on the dividend, but if foreign tax was withheld from the dividends, you get the foreign tax credit. For example, if the fund earned $1000 in dividends and $100 was withheld in foreign tax, the distribution is $900. You pay $150 tax on the full $1000, but you will usually be able to take the $100 as a credit, so your net tax is only $50. (Caution: If your income is very high or you have a lot of foreign income, the foreign tax credit on qualified dividends may be based on .4286 of the income, which could limit your credit; see the IRS Form 1116 instructions for details.)

If you are moving between two funds which pay dividends at the same time, you want to move after the dividend payment; you will pay tax on the dividend either way, but you have a lower capital gain if you sell after the distributions.

Wait for deadlines
There are several tax rules which depend on the holding period, so you may need to postpone a transaction in order to get the benefit of the deadline.

Wash sales
You have a wash sale and cannot immediately deduct your loss if you sold a fund at a loss and buy back a substantially identical fund within 30 days before or after. If you would otherwise have a wash sale, wait 31 days to buy the same fund (even if the purchase is in an IRA or 401(k)). If you purchased a fund less than 31 days ago, either wait until the 31 days are up before selling any shares of that fund at a loss, or, using Specific Identification of Shares, sell the shares purchased within the last 31 days as well as any other shares you want to sell.

Waiting for long-term gains
If you have substantial gains in a fund, you will have a considerable tax savings if you wait until you have held the fund for a year and a day, so that the gains are taxed at the lower long-term rate.

If you have both long-term and short-term gains this year, then short-term losses will offset the short-term gains, while long-term losses will offset the long-term gains. Therefore, if you have both types of gains, you should try to sell at a loss before the loss becomes long-term.

Special rule for losses on tax-exempt funds
If you have a loss on fund shares which paid tax-exempt interest, you cannot deduct a loss up to the amount of interest earned on shares held six months or less. Therefore, wait at least six months before selling such shares if the loss is significant (and, in the meantime, do not reinvest distributions in the fund). See the references in Links for more details.

There is a similar six-month rule for claiming short-term losses on shares which paid out long-term capital-gain distributions, but this is not usually a serious consequence because it merely converts short-term losses to long-term losses rather than eliminating them altogether.

Links

 * IRS Publication 564, Mutual Fund Distributions
 * Fairmark mutual fund tax guide