On Friday I mentioned one useful thing you can do with your portfolio during market declines (i.e., rebalance your asset allocation). Today I wanted to discuss another: check your taxable accounts for opportunities to tax-loss harvest. (Note: tax-loss harvesting does not apply to IRAs or other tax-sheltered accounts.)
To explain what tax-loss harvesting is, let’s look at an example.
Mary is in the 25% tax bracket. At the beginning of the year, Mary bought $100,000 of Vanguard Total International Stock Index Fund in her taxable account. As of today, it’s worth approximately $93,000. To tax-loss harvest, Mary would sell that fund, thereby recognizing a $7,000 capital loss.
Mary can use this $7,000 capital loss to offset any capital gains she realized this year. And if Mary’s capital losses exceed her capital gains for the year, she can use up to $3,000 of her net capital loss to offset ordinary income, thereby saving her $750 ($3,000 x 25%) on income tax. If she still has remaining capital losses after that, they can be carried forward to be used in future years (subject to the same limitation).
Potential Pitfall: Wash Sale Rule
Of course, after selling one of her holdings to realize a capital loss, Mary’s asset allocation will be out of whack.
But she must be careful! If, within 30 days before or after the date on which she sells her fund for a loss, she (or her spouse) purchases a “substantially identical” investment, she will have executed what’s known as a “wash sale.” And that means that the loss will be disallowed. (Essentially, it will be treated as if she hadn’t sold the fund at all.)
In other words: After selling an investment in order to tax-loss harvest, do not immediately repurchase the same investment. Instead, you have two choices:
- Wait 31 days before repurchasing it, or
- Purchase a fund that is similar but that would not qualify as “substantially identical.”
For example, if you go with option #2, any of the following funds is a relatively-close replacement for the fund(s) it’s paired with:
- Vanguard Total International Stock Market Index -> Vanguard FTSE All-World Ex-US Index
- Vanguard Total Stock Market Index -> Vanguard Large-Cap Index -> Vanguard 500 Index
- Vanguard Total Bond Market Index -> Vanguard Intermediate-Term Bond Index*
(Note: It likely makes sense to switch back to your original holding at some point though, given that these funds are different from each other.)
What’s the Point?
You may have noticed, however, that when you eventually sell the replacement fund, your capital gain will be larger than it would have been had you not tax-loss harvested (because the replacement fund will have been purchased at a lower price than the original fund).
To return to our example above, if Mary uses her $93,000 to purchase Vanguard FTSE All-World Ex-US Index, which she sells a few years later for $130,000, her long-term capital gain will be $37,000 rather than $30,000.
So did Mary still come out ahead? Yes, for a few reasons.
First, if nothing else, she deferred her taxes for a few years–in essence getting an interest-free loan from Uncle Sam.
Second, if she was able to use any of her $7,000 capital loss to offset ordinary income (or short-term capital gains), then the capital loss saved her money at a rate of 25% (because she’s in the 25% tax bracket). When she sells the replacement fund, the long-term capital gain will only be taxed at a rate of 15%.
Finally, if Mary had ended up dying before she sold the fund, the savings from tax-loss harvesting would be pure profit (because her heirs will receive the fund’s current market value as their cost basis when they inherit it).
When to Tax-Loss Harvest
Many investors check for tax-loss harvesting opportunities right before the end of the year–when they start thinking about taxes. While that’s perfectly fine, it can be advantageous to check several times throughout the year. Investments can be volatile, and it’s entirely possible that a tax-loss harvesting opportunity will arise early in the year, only to disappear before year-end.
*To the best of my knowledge, the IRS has not actually issued any firm guidance on what constitutes a substantially identical security when it comes to mutual funds. Personally, I’d be comfortable taking the position on a tax return that none of the above-mentioned pairings are substantially identical, given that they track meaningfully different indexes. But if you want to be absolutely sure, your best bet is to just wait 31 days, then repurchase the original fund.
Having not thought a great deal about this, I always kind of figured that the mutual fund pairings you provided would be considered as “substantially identical” because they mostly own the same underlying assets.
But I realize that you are probably right about this. Or at least, if the IRS challenged someone, they could make a persuasive case that such funds are not substantially identical.
Thanks, Wade
This is certainly timely advice.
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Thank you – very timely advice indeed. I’m curious how you interpret the phrase “30 days before or after the date…”. Would you interpret the before part to mean that you have to own any given fund for at least 30 days before you can tax-loss harvest?
balmalocha: If you buy an investment and sell it within 30 days, you can still claim a loss, provided that you have no other purchases of that investment (or one substantially identical to it) within the relevant window.
The purpose of that phrase is to prevent something like this:
Jason has $10,000 of Fund A that he wants to sell for tax-loss harvesting purposes. But Jason also wants to keep that fund included in his portfolio.
In an attempt to get around the wash sale rules, he buys an extra $10,000 of Fund A immediately before he places his sell order for the original $10,000 of the fund. His hope is that he now gets to claim the loss for the sale, without having messed up his asset allocation.
But, this plan does not work because of the “30 days before or after” phrasing. Jason’s loss will be disallowed as a wash sale.
Thanks for that clarification. The *before* part didn’t make sense to me, and I was getting some differing opinions on what it means. I think shall be tax-loss harvesting for the first time pretty soon.
Seems like you picked the perfect market swings to talk about tax losses. You must be bloody psychic.
I did more tax loss harvesting than I would have liked today :>
It’s rough out there!
But heck, I had a few long-short type plays and when I went way into the red on some, to stem further declines and offset earlier gains with some losses, I did strategically look at tax loss harvesting today as a strategy. Great article!
Another potential pitfall: selling low. I never use tax-loss harvesting as a selling strategy. I use it as a consolation prize to make myself feel better when I’m selling something I no longer want and wishing I had better timing.
Good point about the lower taxes later, though. I hadn’t thought of that.
Cleaver idea on the tax loss harvesting! I like it.
However, I’m a little conflicted on the advice about rebalancing during the market downturn. Personally, I would think that passive investors should only rebalance is it is the scheduled time of the month/quarter/year for them to do so.
If they rebalance just in light of the recent downturn, would that not be adopting an active approach?
Jacob,
Good question. I for one don’t think it matters whether or not it’s “active.” All that matters is whether or not it’s a good idea.
Some people argue that rebalancing at moments of high volatility can lead to higher returns (by taking advantage of mean reversion). Personally, I’m doubtful of how reliable that is. In my opinion, rebalancing is about maintaining a stable level of risk (in the volatility sense) in your portfolio. If market movements have moved you significantly from your target allocation, I think it’s entirely reasonable to rebalance back to that allocation (especially if there’s no transaction cost involved).
That said, for those who don’t check their portfolios very often (me, for instance), I don’t think there’s much harm in just rebalancing once every year or two.