Scenario:
I own a income bond fund in a taxable account that distributes monthly dividends. These dividends may either be directed to cash or used to repurchase additional share of the income fund. My brokerage calculates this dividend distribution as a loss in share price for the fund, but my total return has remained the same since (I have more share or cash in addition to the remaining shares albeit at a lower price).
If I repurchase share with the dividends:
My ACB (Average Cost Basis) of all shares should be theoretically lower since these dividend distribution adjustmented the share price lower and the subsequent repurchase of additional shares were bought at this lower price, but these dividends are also report-able as income in a taxable account.
This added income tax may prompt a decision to sell shares to pay the taxes on the dividends (since this cash was used to to repurchase shares). This selling adds another layer of report-able distributions (which may be either short or long term capital gains) for tax purposes. This seems inefficient.
Wouldn't taking dividends as well as long or short term capital gains in cash be a better way to managed (tax wise) these distributions?
Comments
If you need the cash (either for spending or rebalancing), then you might as well keep it. That's what you seem to be implying by saying that you'd have to sell shares to pay the taxes owed.
So the question might be viewed instead as one of where to park that cash for the short term - say six months until your tax bill comes due. If you park it in a MMF or bank account, you'll get more divs (MMF) or interest (bank). So while keeping the cash may appear simpler, because, well, it's just cash, that approach still generates more report-able distributions.
If you park the cash in your bond fund (say, by reinvesting divs), then you've got cap gains (when you sell) as well as more divs from the bond fund. Slightly more complex, but not fundamentally different.
A couple of additional thoughts:
- For tax efficiency, it's usually better to sell specific shares than use average cost. That lets you pick shares with the highest cost, generating the lowest cap gains or possibly even losses. (Of course you pay for that in the future, because your remaining shares have the lowest cost, hence the highest gains when you ultimately do sell them.)
- Some bond funds declare daily, and pay monthly. For these funds, the share price doesn't drop when there's a distribution, because the daily dividends are not incorporated into the share price. (If you liquidate your position in the middle of the month you get not only the value of the shares but the accrued dividends through the partial month.)
I find it somewhat disheartening when brokerage firm's tax advice defaults to, "be sure to consult your tax advisor"...as if I have one.
Thanks Again.
The very short answer may be #2 below: you keep track of costs yourself. The broker/fund company doesn't report non-covered share costs to the IRS.
The rules really haven't changed for non-covered shares with the advent of covered shares. (Except that one can no longer use average cost, double category. Don't worry about that; it was very obscure.)
1) Once you sell any non-covered shares using average cost, you're stuck with average cost for all your non-covered shares. (The covered shares are handled as a separate batch, so they're not affected by this.)
2) It is your responsibility to keep track of each share's cost. Your monthly statement or trade confirmation has this information. Vanguard writes: "For noncovered shares, Vanguard only has average cost information, so you're responsible for your recordkeeping if you used another method."
3) If you don't tell the broker/fund which shares you're selling, you're automatically selling the oldest ones first. (This is true even if you're using average cost, it's just that all the shares, oldest or newest, are treated as though they cost the same.)
4) If you tell the broker/fund which shares you're selling when you sell the shares and they acknowledge your notification, then you can select different shares to sell. It only has to acknowledge which shares you're selling, not the cost you're using.
For example, say you've got one lot of 100 shares you bought on 1/2/2010 @$10, and another lot of 100 shares you bought on 1/2/2012 @$20. (You might also have some covered shares.)
If you tell the broker/fund to sell the shares bought on 1/2/2012, and the broker/fund acknowledges this (some will, some won't), then you've sold those shares with a total cost basis of $2,000 (100 x $20). You still have the 1/2/2010 shares to sell later.
One of the reasons why I prefer Fidelity is that their online system has accepted (and acknowledged) specific share identifications for many years. I also have shares at fund families where they refuse to acknowledge anything about non-covered shares. So then I'm stuck with the oldest shares being sold. I either use average cost or my own records for the actual cost of those oldest shares sold.