I have written many times before about tax-loss harvesting. Tax-loss harvesting is when you sell a security in a taxable/non-qualified/brokerage account at a loss and immediately buy something very similar to it but not, in the words of the IRS, “substantially identical” to it. Up to $3,000 a year of those losses can be deducted from your ordinary income and unlimited amounts can be used to offset both short and long-term capital gains from fund distributions and selling appreciated shares.
If you combine tax-loss harvesting with the step-up in basis at death and/or the contribution of appreciated shares to charity, it can be a very powerful technique that allows you to invest VERY tax-efficiently in a taxable account. You can also give appreciated shares to someone in a lower tax bracket and let them sell them, just beware of the federal and state estate/gift tax exemptions (up to $15K per person per year doesn't count toward the $11.4M exemption on the federal side, but some states have much lower limits).
Don't Reinvest Dividends in Taxable
The Wash Sale
The most common problem is doing a “wash sale.” This occurs when you buy an investment within 30 days before or after the time you sell it. While you are allowed to do that, doing so is a “wash sale” and you cannot now claim that loss on your taxes. The brokerage firms like Vanguard, Fidelity, Schwab, and eTrade are very good at keeping track of this stuff so long as you are doing all of your buying and selling at their brokerage/mutual fund firm. If you have multiple accounts at multiple firms, they won't be able to help you and you'll need to keep track of it yourself–the rules still apply.
In fact, the rules even apply if you sell one fund in your taxable account and buy it within 30 days before or after the sale in your IRA. Some have even speculated that this “IRA Rule” applies to your 401(k)s. It seems likely to definitely apply to your individual 401(k), but whether it applies to an employer's 401(k) is a little less clear. The most conservative avoid it, while the more cavalier are well aware that neither IRAs nor 401(k)s actually report your specific investments to the IRS and spend much less time worrying about this issue.
So the biggest thing to worry about with regards to the wash sale rules is selling and buying and selling and buying too fast. For example, if you exchange from the Vanguard Total Stock Market Fund to the Vanguard 500 Index Fund (not substantially identical but still with a 0.99 correlation) and then back to the Total Stock Market Fund two weeks later, you've done a wash sale. Likewise, if you buy the Total Stock Market Fund two weeks before exchanging some other shares of the fund to the 500 index fund (although note if you also sell the TSM shares you just bought, that is not a wash sale). This is a good reason not to put a taxable investing program on autopilot with frequent purchases. Less frequent, larger purchases are much easier to keep track of for tax-loss harvesting purposes.
That's exactly what burns people when it comes to reinvesting dividends. While I reinvest all my dividends in IRAs and 401(k)s, I do not do so in a taxable account. It creates lots of tiny tax lots that can be complex to keep track of (although the brokerages do a nice job), but most importantly, it means I'm buying a fund as frequently as every month, making it very tricky to avoid wash sale rules. So my general advice is don't reinvest your dividends in taxable in any investment with potential to appreciate (obviously it's fine in a fund where all returns are paid out regularly such as a money market fund or hard money loan fund.)
Beware the 60-Day Qualified Dividend Rule
Most people who have been tax-loss harvesting for a while know all about the wash sale rules (and have likely violated them once or twice.) What they may not be aware of, however, is the 60-day rule for qualified dividends. Stock dividends (including those distributed through a mutual fund) are either qualified with the IRS or non-qualified (like bond dividends.) The idea behind qualifying some dividends and not others is to encourage long-term investment. So one of the qualified dividend rules is that you must hold the investment for at least 60 days around the ex-div date (i.e. when the dividend is paid). So perhaps 45 days before the ex-div and 15 days after. Or 10 days before and 50 days after. If you don't hold the stock or fund that long, the dividend is NOT qualified, meaning you'll pay taxes on it at your higher ordinary income tax rate instead of the lower qualified dividend rate. That could mean paying up to 20% more in taxes on those gains.
So the bottom line is don't get into the habit of frenetically harvesting losses. Not only are you more likely to end up with a wash sale, but you may turn dividends that would otherwise be qualified into non-qualified dividends.
What do you think? Have you screwed up either the wash sale rule or the 60-day rule? What happened? How do you invest tax-efficiently in a taxable account? Comment below!