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 will 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.

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.

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.

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