Tax Loss Harvesting and Qualified Dividends: Two Important Considerations for Portfolio Construction

Tax Loss Harvesting

What is tax loss harvesting?

Tax loss harvesting is a tax strategy you can use to offset some of the gains realized on the sale of a profitable stock, while still maintaining the overall value of your portfolio. While tax loss harvesting can take place at any time, the end of the year is an excellent time to take advantage of this strategy as a way to balance portfolio performance.

How does tax loss harvesting work?

Here’s how tax loss harvesting works:

1. You sell an underperforming stock at a loss.
2. Up to $3,000 of that loss can be used to offset your gain per year. If the loss is greater than this limit, you can carry the balance of the loss into future years, deducting up to $3,000 each year.
3. To rebalance your portfolio, you then reinvest the funds from the sale of the underperforming stock back into a different stock option.

Retirement accounts do not qualify, and you cannot purchase a “substantially identical security” within the 30-day window of the sale without triggering the wash-sale rule and therefore barring you from taking the deduction.

Ordinary vs. Qualified Dividends

When constructing your portfolio, you’ll want to know the difference between ordinary and qualified dividends. Qualified dividends are taxed as the lower capital gains tax rate whereas ordinary dividends are taxed as ordinary income — which means a greater tax obligation for high-net worth individuals.

What makes a dividend qualified?

In short, a qualified dividend must meet the following criteria:

• It is from a U.S.-based company or a qualified foreign company.
• It meets the required holding period.

Are there other dividends that do not qualify?

Aside from the criteria above, the IRS excludes some other types of dividends, like real estate investment trusts and master limited partnerships. Employee stock options and dividends paid from both tax-exempt entities or money market accounts are excluded, as well.

And as the IRS notes, the responsibility of identifying whether a dividend is qualified or ordinary falls to the payer: “The payer of the dividend is required to correctly identify each type and amount of dividend for you when reporting them on your Form 1099-DIV.”

What is the holding period for a qualified dividend?

Dividends must be held for a certain period of time to be considered qualified. Generally, this is “more than 60 days during the 121-day period that begins 60 days before the ex-dividend

date.”

The IRS provides the following example:

“You bought 5,000 shares of XYZ Corp. common stock on July 5, 2021. XYZ Corp. paid a cash dividend of 10 cents per share. The ex-dividend date was July 12, 2021. Your Form 1099-DIV from XYZ Corp. shows $500 in box 1a (ordinary dividends) and in box 1b (qualified dividends). However, you sold the 5,000 shares on August 8, 2021. You held your shares of XYZ Corp. for only 34 days of the 121-day period (from July 6, 2021, through August 8, 2021). The 121-day period began on May 13, 2021 (60 days before the ex-dividend date), and ended on September 10, 2021. You have no qualified dividends from XYZ Corp. because you held the XYZ stock for less than 61 days.”

In this example, the dividends paid would be taxed as ordinary income.