In January just passed, we began our 17th year of investing only for the income our portfolio produces each year. All of our investment income flows from a taxable joint account, and overall we're very happy with how dividend-paying stocks have provided for the growing retirement income we require. But I would be less than honest if I implied that we have somehow been smart (lucky?) enough to never pick dividend cutting stocks or we pick dividend paying stocks whose price has only gone up after purchase. Nope, we've had our fair share of rotten tomatoes over the years! Names like EXC, PFE, CXW, NLY, and more recently, HCP and VNRAP are all contributing members of our income portfolio historic hall-of-shame. Or perhaps income ETFs like JNK that have a gradually declining NAV. I like to think that careful selection will avoid most such dividend cutters with the sharp price declines that always follow, or that we pick dividend payers that are currently fairly priced and not way overvalued and set for a price correction. But despite careful analysis of dividend histories and recent trends in cash flows, dividend cutters and expensive income stocks will somehow manage to wiggle into the income portfolio of many. And although true, income investors will not discard a stock due solely to a price decline, the decline in value is real and so the opportunity for tax loss selling still exists even though the dividend may be secure. So the next question is, what to do. Should losses be taken at the end of each year? Should losses be kept and used only during years of large realized capital gains. Should they be taken if the stock's price drops a certain percent? Should the loss be taken immediately when the dividend cut is announced and the net proceeds immediately redeployed? Or should transient price declines of otherwise reliable dividend payers simply be ignored? Like all financial planning answers, it depends on multiple conditions. Certainly, these are worthy questions the income investor must contemplate before realizing (actually selling the stock) the capital loss. So in this article, I'll only be looking at long-term capital losses (LTCL) as offsets to long-term capital gains (LTCG) in a taxable account, when either the stock has not cut the dividend, but is part of a broader market sell-off or with the assumption the decision has been made to sell the dividend cutting (or soon to be dividend cutting) stock as soon as is feasible. The analysis for the actual timing of this I'll leave as the topic of another article. But having said that, as a general rule, I avoid trying to time losses on non-dividend cutting stocks, as the risk of a sharp price growth during required waiting period (see next) is too great. So if tax loss harvesting will provide useful tax savings, I'll generally try to sell and immediately replace with an equivalent dividend-paying stock, if available.
The Internal Revenue Code specifies that in order to qualify as an LTCL, the same (actually, 'substantially identical') stock cannot be purchased during the 30 days immediately prior to or immediately following the loss sale date, which includes a contract or option to acquire the same stock. If such a purchase has been made, the loss will be disallowed and the amount of the loss will be added to the basis of the acquired shares. For the income investor who wishes to keep the dividend paying stock but only recognize the loss, it will be important to take the loss at least 31 days before the stock's Ex-Dividend date, so as not to miss the dividend. For a monthly paying dividend stock, the loss sale will miss one monthly dividend, and so this dividend loss must be part of the calculation of expected financial benefit of a loss sale.
Sources of LTCG to the Income Investor
For the true Income Investor, realizing LTCGs may seem an oxymoron. Income investors do not generally sell reliable dividend paying stocks, as the dividend income lost from the sale generally must then be replaced with another dividend payer. But the market is a pretty efficient pricer of dividend payers, so to avoid a cut in portfolio income, the replacement dividend payer will most likely have to be of higher income risk… which is okay if that is the plan. But LTCG can be involuntary in an income portfolio, as they may be part of the distributions of funds (open end, closed end or ETF) or REITs or possibly Business Development Companies. Because equity REITs tend to play a prominent role in most income portfolios, LTCG distributions (line 2a of form 1099-DIV) can be significant in a given year. And then there are those annoying involuntary redemptions of preferred stock that can create unplanned LTCGs as well as the occasional dividend payers who are taken private or bought out by another company in an all cash transaction (think GAS in 2016). So one way or another, the true income portfolio has a strong likelihood of experiencing annual LTCG distributions even though the income investor is not selling to 'take profits.'
Tax Treatment of Long-Term Capital Gains (LTCG) and Short-Term Capital Gains (STCG)
The Jobs and Growth Tax Relief Reconciliation Act of 2003 temporarily created, and the American Tax Payer Relief Act of 2012 made permanent, the 0% and 15% tax rate for qualified dividends (QD) and LTCGs, at least until the tax laws are again changed. For QD and LTCG that fall under the 25% Federal tax bracket, the tax rate is 0%, while those that fall within the 25% to 35% tax brackets are taxed at 15%. For higher income retirement households with modified Adjusted Gross Incomes (AGI) in excess of $250,000 and those in the 39.6% tax bracket will be subject to a greater tax rate on QD and LTCG, but I won't go into that here, as this is unusual for most retirement households. Net STCGs receive no such special tax treatment and are simply included as ordinary income.
If the taxpayer has multiple LTCG, LTCL, STCG and STCL, although it would be unusual for an income investor to have all of these in a given year, Schedule D will net out Long-Term gains and losses and then net out Short-Term gains and losses. If both long and short capital gains are positive, they will be carried onto the form 1040. If one is positive and one negative, they will be netted out and if the result is an LTCG, it will be carried to the form 1040. If the net is an STCG, it will be added to ordinary income. If the net is a loss, up to $3,000 of it will be used as a negative ordinary income….that is…..up to -$3,000 will be entered on line 13 of form 1040. Any remaining unused capital loss, short or long term, will then be carried forward to the next year's tax return. Another interesting tidbit…..STCG distributed by mutual funds are not distributed as a capital gain but instead are reported as ordinary dividends and so will go directly to the 1040 as ordinary income. And mutual funds may not distribute capital losses, but retain them to be used against future capital gains at the mutual fund level.
For the retired household, most ordinary income will come from these sources:
- Any wages from part time employment or net self employment
- Income Distributions from Traditional IRAs or Employer retirement plans (with no basis)
- Up to 85% of Social Security benefits
- Corporate bond interest
- Non-qualified dividends ((NonQD))
- Pension payments.
Ordinary income is combined into one number and after all deductions, is taxed at the tax table rates. For a couple married filing jointly (MFJ) in 2017, the first $18,650 of ordinary income after all deductions, is taxed at the 10% rate, the next $57,300 (from $18,600 up to $75,900 of ordinary income) is taxed at 15% and ordinary income in excess of $75,900 up to $153,100 is taxed at 25%. For tax purposes, all ordinary income is combined and goes on the "bottom of the stack"
Stacking household income
I've found that 'stacking' household income (see below) is a much easier way to see what is going on and how taxes are calculated. So the best way to show this is with an example:
John and Mary, ages 66 and 68, are a fairly typical retired household. They've elected to invest their taxable retirement savings in dividend paying stocks and ETFs that distribute QD, taxable interest and a smaller amount of capital gains distributions each year primarily from equity REITs. Other household ordinary income includes their Social Security benefits, Mary's pension and John's Traditional IRA (TIRA) withdrawals.
The Adjusted Gross Income represents all income subject to taxation, which will include all forms of ordinary income, QD and LTCG. This is why it's important to think of QDs and LTCGs NOT as being tax-free…. they ARE subject to taxation but at the 0% rate if they fall in the 15% Fed tax bracket. Tax free distributions, as shown on John and Mary's income statement as Return of Capital and Qualified Roth IRA withdrawals, are not included in the couple's AGI, while QD and LTCG are part of AGI.
Note that ordinary income always goes on the bottom of the stack and that all deductions, whether taken 'above-the-line' (on the front of form 1040), itemized or standard deduction and personal exemptions… all are taken from ordinary income off the "bottom of the stack." In this couple's case, their deductions + personal exemptions total $23,300. This is subtracted from their AGI to arrive at their Taxable Income. In the stacked bar to the right, these deductions have been 'pulled out,' thus allowing the whole chart to 'clunk' down by $23,300, while the top of the 10% and 15% tax bracket lines remain fixed. As can be seen, the QD and LTCG have moved down, but are still in the 25% bracket and so will be taxed at the 15% rate. (Note, after this stacked bar, I'll not show the 10% bracket as none of this discussion will involve it.)
To harvest or not to harvest that LTCL
It's December 2017 and for the year, John and Mary have had two preferred stock redeemed that has resulted in $6,000 in a net LTCG. In addition to this, the REITs they've held for many years they expect this year to distribute about $2,000 in LTCG, which will combine to provide an estimated $8,000 in LTCG to the household for 2017. Now, let's say Mary invested in shares of XYZ REIT purchased in the previous year when its 4.2% then current yield was $71/share, but now the price has dropped to about $60/share. They think this is a quality stock they want to keep, but just bought it at the wrong time. If they wish to harvest the LTCL they could sell, wait 31 days and repurchase it, or, they could sell and buy a close replacement if one exists. Because the stock pays a monthly dividend and the share price tends to be a bit too volatile for them to risk selling and waiting, and because there is a similar stock to replace it, they decide to sell XYZ and buy the similar replacement REIT immediately with the net proceeds. Mary has determined that this sell/replace will have little-to-no effect neither on the total dividend received nor on portfolio income risk. The LTCL, net of transaction costs, will be -$10,000. So the important question is: Will tax loss selling provide a significant financial benefit for John and Mary that will warrant the time and risk of actually taking it?
Looking at the above stacked bar chart of Taxable Income, we can see that the $8,000 of estimated LTCG is all within the 25% bracket. Thus selling and taking the -$10,000 loss will generate the following tax savings
- 8,000 X .15 = $1,200 tax reduction by eliminating the LTCGs
- 10,000-8,000 = 2,000 of unused LTCL that can then be used as negative income to reduce ordinary income from the 25% bracket = .25 X 2,000 = $500 of tax savings
- Total tax savings = $1,200 + $500 = $1,700
Clearly, harvesting this tax loss is worth it at this AGI.
But what would happen if their AGI were smaller. Would the tax savings still be worth the time and effort to capture the LTCL to use against gains. To test this, I lowered John and Mary's AGI in two scenarios, as the above income table shows. The following is the stacked bar for scenario #2.
By reducing their AGI a bit, part of the QD and LTCG are in the 25% bracket and part in the 15% bracket.
At first glance, it might appear that the $10,000 LTCL would have little effect, as the LTCG is entirely in the 15% bracket where it is subject to the 0% tax rate and the remaining $2,000 of LTCL would only reduce tax by 15% of 2,000. But by removing the LTCG + $2,000 of ordinary income, $10,000 of the QD will drop down from the 25% bracket into the 15% bracket, where it will then be taxed at the 0% rate. Here is the math of the tax savings from taking the $10,000 LTCL under this income condition:
- 75,900 - (67,550 + 8,000) = $350 of QD already in the 15% bracket
- $10,000 of QD will drop down into the 15% bracket = 10,000 X .15 = $1,500 tax reduction
- $2,000 of ordinary income in the 15% bracket will vanish = 2,000 X .15 = $300 tax reduction
Total tax savings: $1,500 + $300 = $1,800
This lower level of household income would actually result in a slightly greater tax savings from the $10,000 of LTCL compared to the higher AGI in scenario #1.
But what happens if we drop their AGI even further?
In this third scenario, the pension has been dropped to zero, SS, NonQD and QD-LTCG remain unchanged and TIRA has been increased back to $20,000. This puts all of the QD and LTCG in the 15% bracket and therefore taxed at 0%. This would seem to make taking the $10,000 LTCL an exercise in wasting a capital loss. But sometimes eyeball analysis can be deceiving!
The major difference in this scenario over the first two is the change in how much of Social Security must be included as ordinary income which has nothing to do with the tax treatment of QD and LTCG. In the first two scenarios, 85% of the household's $45,000 of Social Security, $38,250, was included as ordinary income. In this scenario, before the $10,000 LTCL, 82.3% or $37,025 of household Social Security is included as ordinary income, but with the $10,000 LTCL subtracted from AGI, $28,525 or 63.4% of household Social Security is included as ordinary income. So the tax savings from taking the $10,000 LTCL is
- 37,025 - 28,525 = $8,500 decline in ordinary income from reduced Social Security as ordinary income = 8,500 X .15 = $1,275 in tax reduction
- The elimination of $8,000 of LTCG in the 15% bracket = no change in tax liability
- 10,000 - 8,000 = $2,000 decline in ordinary income in the 15% bracket = 2,000 X .15 = $300 in tax reduction
- $1,275 + $300 = $1,575 in tax reduction.
The following is a summary of the tax savings from the $10,000 LTCL when applied to the three above scenarios.
This article looks only at the one-time tax savings of realizing a LTCL under 3 income scenarios where QD and LTCG are realized in a taxable account. Although I do briefly speak to it, the article does not analyze how to determine if the long-term income may be affected. It is the responsibility of each income investor to ensure the household income is not negatively affected by the decision to realize the LTCL....in this example, it's assumed taking the LTCL will not have an adverse effect on continued portfolio income or the income risk.
The potential tax savings from harvesting a capital loss can only be determined by considering the entire tax return and not just the reduction or elimination of LTCG by itself. The final tax savings will depend on where the existing LTCG 'stack' in which tax bracket, the amount of 'unused' LTCL after offsetting capital gains (up to $3,000) and the tax bracket of the ordinary income it reduces, and the amount, if any, of the Social Security that will be removed from ordinary income (the reduction in AGI) by taking the LTCL. Every tax return will be affected differently so the ultimate tax benefit will vary.
But as is clear from this analysis, John and Mary would benefit from realizing the loss in all 3 scenarios. And of the 3 scenarios, the most beneficial for most would likely be the third (lowest AGI), as taking the LTCL will create an additional $18,500 of 'head room' in the 15% tax bracket: $10,000 from the LTCL and $8,500 reduction in the amount of Social Security treated as ordinary income which when combined with the 'headroom' prior to taking the LTCL provides $22,675 of total headroom in the 15% bracket after taking the LTCL. This gives John and Mary the opportunity to use this additional 'space' to do a Roth conversion (taxed at 15%) or perhaps to do a sell/repurchase of highly appreciated dividend paying stocks to step-up basis. However, the amount of the conversion and/or sale/buyback will be less than $22,675. This is because as the AGI increases, so will the amount of SS that must be included as ordinary income. I will leave the calculation of this amount to the reader.
The tax savings for each scenario above I verified by creating a tax return in TurboTax for 2016, although in my calculations I used deductions and tax brackets for 2017. Initially I used online tax estimators, which I found could vary widely. For example, the estimated tax for 2016 for the scenario #1 before taking the LTCL was as follows:
H&R Block: $12,872
Tax Act: $12,752
Liberty Tax: $17,071
Jackson Hewitt: $17,055
TurboTax Tax return: $17,056
Some of the extimators did not differentiate between ordinary dividends and qualified dividends and some did not specify whether the Social Security entry should be gross amount or taxable amount. Of these tax estimators, I found Jackson Hewitt to be the most detailed although not the easiest to use.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.