Tax-loss harvesting is all the rage these days. I've done it several times since the start of this bear market and booked hundreds of thousands of dollars in tax losses. However, there are a few reasons why you may not want to do it. Before I get into them, let's briefly review the concept.
What is Tax-Loss Harvesting?
You are allowed to deduct up to $3,000 per year of a short or long term capital loss from your ordinary income on your taxes. Losses also offset gains. This all takes place on Schedule D of IRS Form 1040. These losses are so useful that investment advisors, tax preparers, and financial gurus the world over recommend you book them any time you can. However, taxable losses generally show up after an investment goes down in value, not exactly the time you would normally sell an investment. Buying high and selling low is a losing proposition most of the time. Thus the birth of tax-loss harvesting. When tax-loss harvesting, you get to claim the loss without ever selling low. You do so by simply exchanging one investment for a very similar (but, in the words of the IRS, “not substantially identical”) investment. Thus you're still fully invested (and so haven't “sold low”) but still get to use the loss on your taxes.
An Example of Tax-Loss Harvesting
A typical exchange might be to swap the Vanguard Total Stock Market Fund for the Vanguard 500 Index Fund. These two funds have a correlation of 0.99, but nobody in their right mind could argue they are substantially identical. The first holds thousands of more stocks than the second, they have different CUSIP numbers, and they follow different indices.
So perhaps you bought the Total Stock Market Fund with $10,000. Then a bear market happens. Your investment is now worth $7,000. So you put in an order to exchange it to 500 Index Fund. The next day you discover you own $7,000 worth of 500 Index Fund. The bear market recovers and you now have $10,000 worth of 500 Index Fund and you have a $3,000 tax deduction. That's like making $1,000+ in cold, hard cash.
So if tax loss harvesting is so awesome, why would anyone NOT want to do it? Well, there are a few reasons, including some classic mistakes, pretty much all of which I have made myself at some point.
# 1 Wash Sales
The biggest reason not to tax loss harvest is if you won't be able to get a loss out of it anyway. This often happens if you perform what is called a “wash sale.”
A wash sale is when you buy the shares back within 30 days (before or after) the date you sell them. If you do so, your tax basis (i.e. what you paid for it) is carried into the new shares. So essentially, if you do an exchange to tax loss harvest, you can't go right back to the old investment the next day. You have to wait a month. Note that this wash sale period also includes the 30 days BEFORE the exchange, which makes things a little confusing. It doesn't mean you can't exchange something you just bought. It means you can't buy new shares and then sell the old shares and claim the loss.
Three examples to illustrate the point:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange Fund A for Fund B.
You now have a $10,000 tax loss. No wash sale.
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares. You now have $180,00 and 20,000 shares of Fund A
- Day 6: You exchange 10,000 shares of Fund A for Fund B.
You have no tax loss. This was a wash sale.
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares for $90,000. You now have $180,00 and 20,000 shares of Fund A
- Day 6: You exchange 20,000 shares of Fund A for Fund B.
You now have a $10,000 tax loss. No wash sale.
# 2 The 60 Day Dividend Rule
Frenetic tax-loss harvesting often causes an investor to fall afoul of the 60-day dividend rule. If you don't own a mutual fund for at least 60 days inclusive before and after a qualified dividend is paid, that dividend becomes unqualified. So now you will pay tax on it at your ordinary income tax rates rather than the lower qualified dividend rates.
Again, an example:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 3: Fund A pays a dividend of $500
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange them all for Fund B.
Now instead of paying $500 * 23.8% = $119 on that dividend you pay $500* 37% = $185. If you had made the exchange on Day 61, that dividend would have been qualified.
Class III rapids? No problem for these kids.
In order to avoid running afoul of this rule, you need to know when your investments are going to pay out qualified dividends and avoid frequent tax-loss harvesting around those dates. You could wipe out the entire benefit of tax-loss harvesting in additional dividend tax costs.
# 3 Tax-Exempt Interest Reduction
I'm hesitant to wander this far out into the weeds lest it keeps some people from doing tax-loss harvesting they probably should do. But I'm going to do it anyway in the interest of accuracy.
If you acquire a loss on shares of a mutual fund you have held for six months or less, then the loss is reduced dollar for dollar by any tax-exempt interest paid during that period. However, most tax-exempt funds are not subject to this rule because of the way they accrue and payout interest (i.e. as dividends rather than interest.) The Bogleheads advise:
To see whether a fund is exempt from the six-month rule, check its prospectus for the statement, “dividends are declared daily and paid monthly”; if it says “dividends are declared monthly” (or quarterly), the six-month rule applies.
# 4 Short Term Loss May Be Ruled Long Term
While we're in the weeds, let's cover this topic. Again, if you hold a fund for less than six months and it distributed long term capital gains during that time period, your loss is long-term and not short-term on an amount equal to that distribution. That usually doesn't matter much since either can be used to reduce your taxes, but technically you are supposed to report it that way on your tax return. To make matters worse, Vanguard (and probably most brokerages) don't keep track of this for you as you would expect. So the 1099-B they send you is wrong and you're supposed to correct it yourself by filing Form 8949 and changing the type of capital loss. Frankly, I really doubt the IRS cares much about this and I don't know anyone who would bother to do this, but it is the correct way to report things.
# 5 Might Cause Bad Behavior
Let's get out of the weeds now and get into some useful information.
When it comes to successful investing, the investor matters more than the investment. Your behavior in a bear market will have a direct impact on your returns, your retirement date, how much you can spend, and how much you can give. Staying the course and doing nothing in a bear market is a great way to not do the classic “buy high and sell low” behavior investors, especially physician investors, are famous for. Some people go to an extreme, deliberately locking themselves out of their investing accounts to prevent them from panic selling, not even opening their brokerage statements, and other similar behavioral techniques.
One big issue with tax loss harvesting is it forces you to pay attention to what the markets are doing and actually look at your accounts. If doing so causes you to have to use a less aggressive asset allocation or heaven forbid do something stupid (like selling low) while you're in the account, you would definitely have been better off never tax-loss harvesting at all.
# 6 You Were Only Deferring the Taxes
When you tax loss harvest, you are also lowering the basis (i.e. what you paid for the shares) of your investment. When you eventually sell that investment, you will owe taxes on a larger proportion of the value. An example might illustrate this:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange Fund A for Fund B.
- Day 9,472 You sell your 10,000 shares of Fund B for $250,000. You will owe the following in taxes:
- ($250,000 – $90,000) * 23.8% = $38,080
If you had never tax loss harvested, you would owe the following in taxes:
($250,000 – $100,000) * 23.8% = $35,700
In essence, you now owe $2,380 in additional taxes because of your tax-loss harvesting. That's not necessarily a bad thing, but it depends on what you exchanged it for. Ideally, you were able to use that $10,000 tax loss against ordinary income over 4 years. Saving 37% on taxes and then only paying 23.8% in taxes is a winning move. Same thing if you were able to use the losses against a short-term gain. But even if you were only able to use the losses against long term gains, you still benefit from the use of that money earlier in life, the time value of money if you will. If there were 10 years between when you tax loss harvested and when you sold, and you earned 8% on whatever you invested your tax savings in, that $2,380 in deferred taxes was really worth an extra $2,102.
=((FV(8%,10,0,-2380))-2380)*(1-23.8%) = $2,102
Ideally, you NEVER recapture those losses by either donating the now appreciated shares to charity instead of cash for your charitable contributions or you leave those shares to your heirs to benefit from the step-up in basis at your death. Then you (and your heirs and/or favorite charity) benefit from not only the time value of the deferral of taxes, but also the saved taxes themselves.
# 7 You Should Have Been Tax-Gain Harvesting
A lot of people may not realize this, but if you are not a high-income professional, you may not actually owe much at all in taxes on your taxable investment account. Take a look at the tax brackets for a couple filing “Married Filing Jointly”:
These are also the brackets for qualified dividends. As you can see, if your taxable income is below $80,000, there is no tax due on your capital gains. Don't get me wrong, even with an income under $80,000 you can still use a $3,000 tax loss on your taxes, but it'll only be worth a maximum of $360 given your low tax bracket. If you expect to be in a higher capital gains tax bracket later when you sell these shares, you may wish you had not lowered the basis in your investment just for $360. In fact, lots of people in the lowest tax bracket actually do just the opposite of tax-loss harvesting. They harvest gains by realizing them unnecessarily, constantly increasing the basis on their investments to lower their eventual future tax bill.
# 8 You Already Have More Losses Than You Will Ever Use
Obviously the first $3,000 per year in tax losses that you can use is the most valuable. And of course, you can carry these losses forward indefinitely. They can be used to offset capital gains and could potentially be very valuable at the time of sale of a small business. But at a certain point, a person could have more tax losses than they will ever use.
For example, as I write this post, I have around half a million dollars in tax losses on the books. Obviously, if all I was ever going to be using those for was to offset $3,000 a year of ordinary income, I would have to live another 167 years, which seems unlikely.
So why would I keep accumulating these losses? Well, I used $30,000 in losses in 2019 to offset a short term capital gain I felt was wise to realize, but more importantly, I own all or part of several highly appreciated small businesses that I expect to sell at some point prior to my demise. Up to half a million dollars from those sales will be tax-free. But if you have more losses than you will ever use, there is no point in harvesting more. Remember that losses must be used up by the year the taxpayer dies or they disappear forever.
# 9 You Might Get Burned by Volatility
One of the biggest problems with tax loss harvesting is that it is most useful in the biggest of bear markets. Unfortunately, that is also when markets are most volatile. If you are not careful, or simply not lucky, that volatility can burn you. Let me give you an example of when this occurred recently to me.
I had already tax loss harvested from the Vanguard Total Stock Market Fund to the Vanguard Large Cap Index Fund to the Vanguard 500 Index Fund, all in less than 30 days. And the market had dropped another 15% since. I was sitting on huge losses that I wanted to capture.
I decided the easiest thing to do would be to exchange from the 500 Index Fund to the iShares Total Stock Market ETF. Unfortunately, ETFs trade in real-time, not at market close (4 pm Eastern) like traditional mutual funds. So in order to make this swap, I had to buy the ETF while the market was open and put in an order to sell the mutual fund at market close. So I waited until the end of the day. It was a very volatile day like many of those in a bear market. 15 minutes before market close I bought the ETF. The market was down 9.5% on the day at the time. Unfortunately, in those last 15 minutes of the trading session, the market dropped another 1%+. So I bought high and sold low.
I was unlucky. It could have easily gone the other way, but the difference ( I did something similar with my international stock holding at the same time) worked out to be about $25,000. Is it worth $25,000 to book a several hundred thousand dollar loss? Probably not.
Bear markets and particularly the end of the trading day are notorious times for market volatility. It is best to avoid buying and selling at all during these time periods. So if you choose to wander into that type of environment to do some tax-loss harvesting, don't be surprised if you also get burned.
A great way to avoid this is to use traditional mutual funds in your taxable account. That way you can put in your exchange order and at 4 pm, one fund is sold and one fund is bought. No potential for loss (or gain) on the transaction. But since ETFs tend to be more tax-efficient than traditional index mutual funds (except those of Vanguard which have an ETF subclass), most savvy investors have ETFs in their taxable account.
Thus, you must wander into these dangerous markets if you wish to reap those tax losses. You can try to mitigate it by putting in the buy and sell orders almost simultaneously, but if you use limit orders in a falling market, you are likely to get your buy order filled but not your sell order. Using a market order can also deliver surprises. And of course, the bid-ask spreads tend to widen in times of extreme volatility. Sometimes you'll win, sometimes you'll lose doing this, but be aware of this risk of tax-loss harvesting using ETFs.
As you can see, tax-loss harvesting is a great thing, but it can be more complicated than you might think at first glance, and there are times when you shouldn't bother doing it at all. I've made four of these mistakes myself over the years.
What do you think? How many of these mistakes have you made while tax loss harvesting? Share your tax-loss harvesting success and failure stories below!
Sorry to hear about your unfruitful recent adventures in tax loss harvesting!
I had a similar unlucky transaction, albeit on a smaller scale. I wanted to swap out an emerging markets fund for an ETF at Vanguard for the first time. I put in the sell order on the mutual fund and the buy order on the ETF. The sell order executed at the closing price, but the buy order didn’t execute until the next day’s open.
Of course, the market was up overnight and I got in at a higher price. The delta was about $1,200, so that pretty much wiped out all of the benefit of the harvest.
I’ve made up for it with some of the bad behavior you talk about in #5. Now that I’m trading ETFs, I’ve been known to sell with a market order and put in a limit order a percent or two below the current price. In a declining market, that sell low, buy lower tactic has worked.
Obviously, the strategy could backfire if I happened to sell at the very bottom and my lower strike price is never realized. That clearly has not been a problem thus far. This market and its “opportunities” are testing my good-Boglehead investing behavior.
Cheers!
-PoF
Tax loss harvesting ETFs definitely elevates my heart rate.
I’m like Mark Wahlberg’s character in The Gambler. Just give me one more shot and I know I can make up those losses!
Ha! PoF I think you are literally playing with fire! aren’t you retired? Not sure you want to play around with that nest egg given your recent retirement! what about SORR?
then again seems you’re doing well with your website so really you aren’t retired- just from medicine . . .
I suspect this is a basic question, but I’m relatively new to all of this so I will pose it and ask for your patience: should I consider tax-loss harvesting if all I have is a 401k? Or is tax-loss harvesting just a tool to use with taxable accounts?
Many thanks,
CL
Just taxable.
WCI – Excellent post as always that I enjoyed reading. With respect to #9 where you had already used TSM Index Funds, Large Cap Index Fund, and S&P 500 Index Funds in the prior 30 days and then switched to an ETF to TLH some more, any thoughts on using VTCLX (Vanguard Tax-Managed Capital Appreciation Fund Admiral Shares) as a 4th mutual fund that performs nearly identical long-term to the aforementioned 3? I use this one to TLH but wanted to hear your thoughts on it specifically (and why you used an ETF instead of VTCLX) so I can learn from you. I know the ER is higher for VTCLX than the others, but can you please explain why else you used the ETF you mentioned and not VTCLX. Thanks for all you do.
That would be fine. So would growth index. Obviously wish I’d gone there. The nice thing about ETFs is there are lots of choices out there for my main taxable holdings–TSM and TISM.
In another couple of weeks I’ll be back in VXUS (no March dividend) and when the 60 days run out on ITOT, I’ll go back to VTI.
Many thanks!
I hoped to use VTCLX until I noticed the $10,000 Vanguard Min investment price tag…ugh. I also struggled to figure out if I could use VTI and ITOT as partners. This article helped a lot. Thank You
hopefully that’s ok just TLH’d VTI to ITOT today! tracks different indices, CRSP U.S. Total Market Index vs. S and P Total stock market index
Q for WCI: Would you go back from ITOT to VTI at the end of 60 days even if you have a small gain? Thanks
Maybe. Probably not though. ITOT is fine. A large part of my taxable account gets donated to charity every year and I’d probably eventually use the ITOT shares for that.
This bear market is my first foray in to tax loss harvesting and it’s been hard to keep up, since I’ve been initiating exchanges just about every other day on the way down. Does anyone out there use some kind of app/service to help keep track and avoid wash sales? It would be great to have an app recommend a good fund to move into each time I want to harvest so that I don’t accidentally initiate a wash sale and keep from breaking the cardinal rule and buying something too dissimilar to what I’m selling.
Why not use your brokerage’s app/website? That’s what most use.
I too did my first TLH ever in this bear market and have been doing constantly and am running out of TLH partners! but fidelity makes it easy to track your harvested losses under the “Tax Info (year to date)” tab. I’m sure other brokerages have a similar option to keep track
When you tax loss harvest is the amount you get from selling a fund something we must keep track of ourselves or does Vanguard send you documents to help keep track of this??
Thanks
Michael, I don’t know of an app for that, but I put together a list of TLH partners here: https://physicianfinancebasics.com/tax-loss-harvesting-partners/
It has been a wild ride this month- I am down to ETFs I’ve never used before.
OMG, what a great article thanks so much!!!! great to have summary of TLH partners!!!
Thank you- glad you found it useful!
Can you sell SP500 fund and buy Total Stock immediately
good idea to have etfs to buy when there is a big dip
Yes.
Ken, with ETFs you can sell and buy right away without waiting for the trades to settle. The only caveat, and one that Vanguard will alert you to, is that you cannot go and sell the newly acquired shares for another round of TLH or any other reason, until the trades have settled, about 48 hours or so.
Regarding the 60-day dividend rule, is the entire dividend deemed unqualified or just the % attributed to lots held less than 60 days inclusive.
For example if I TLH $100,000 worth of Fund A today (consisting of dozens of lots going back to 2017), and Fund A pays its dividend tommorrow, what % of the dividend would be unqualified? I’ve not been able to figure thus out on my prior Vanguard 1099s.
I believe just the lots held less than 60 days. The brokerage should take care of it and report it on the annual tax form.
#8 While there may be no point in harvesting losses you will never use, there is also no downside. Start with $1 million in Vanguard’s Total Stock Market. When it hits $500,000, exchange for Vanguard’s Index 500, booking $500,000 of losses.
Several years later, the market recovers, and both the TSM and 500 are back to $1 million when you die. If you had not TLH, your heirs would get the $1 million of TSM with a stepped up basis; with the TLH, your heirs would get $1 million of Index 500 with a stepped up basis.
The difference, as you mention, is that with the booked losses you don’t have to avoid selling at a gain and letting the tax-tail wag your investing-dog.
Regarding the 2 examples
Three examples to illustrate the point:
Day 1: You buy 10,000 shares of Fund A for $100,000
Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange Fund A for Fund B.
You now have a $10,000 tax loss. No wash sale.
Day 1: You buy 10,000 shares of Fund A for $100,000
Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares. You now have $180,00 and 20,000 shares of Fund A
Day 6: You exchange 10,000 shares of Fund A for Fund B.
In BOTH examples you are buying within 30 days. I thought buying and selling within 30 days resulted in a wash sale.
Why does example 1 result in No wash sale, and example 2 result in a wash sale, when in both examples, you bought within 30 days?
That’s the reason for the paragraph and the examples. It’s not a wash sale if you sell ALL shares you own of it within 30 days.
Can accrued mutual fund TLH losses be used to offset capital gains from selling a rental property?
Great question. Rental property taxes are some of the most complicated I know. I think they’re actually a different category of gain/loss so I think the answer is no, but double check this.
They’re called “Section 1250 gains” and more info can be found in Publication 544, Schedule D of the 1040, and Form 4797.
https://www.irs.gov/pub/irs-pdf/p544.pdf
https://www.irs.gov/pub/irs-pdf/f1040sd.pdf
https://www.irs.gov/pub/irs-pdf/f4797.pdf
It appears the short answer is yes. TLH losses first offset in kind gains (short term for short term and long term for long term), but it appears my accumulated mutual fund losses will otherwise offset my rental property capital gains upon selling, as well as release my rental passive carryover loses. Would appreciate any experts correcting me if I am wrong on this, as then I truly will have no need to do any more tax loss harvesting.
May just try plugging in a fake rental sale in my turbo tax return this year to confirm.
I was gifted (UGMA) a few single stocks (XOM, COP) with substantial gains from their cost basis which I have been hoping to unload for some time and replace with indexed mutual funds. I assumed that this would be a good time to do so, but please correct me if I am wrong
Good thinking. Your tax cost will be lower if you make the swap in a bear market than a bull market. Might even capture a loss.
Q for you, WCI: is Mike not going to seal in his losses by selling low? Exchanging individual stocks for index funds is not akin to TLH. Would this be a case of the tax tail wagging the investment dog, or am I missing something? Thanks
It’s even better than TLHing because you get a loss (or at least minimal gain) AND a better portfolio.
I get it now… it’s because he inherited it. so none of my concerns hold true. Thanks!
How do you know if the fund/etf you’re exchanging for is ok to do? e.g. the vanguard 2040 target date fund, I have it in my taxable account…what could I exchange it for? 2045 target date fund? or is that too similar. Is there a good resource for how different the exchanged fund/etf has to be?
Lots of debate out there on this but the bottom line is if the CUSIP number is different, your brokerage doesn’t care. And if your brokerage doesn’t care, the IRS doesn’t care. I have yet to hear of anyone audited on this issue.
Question for The White Coat Investor / Physician on fire,
In the past I have only TLH mutual funds (easy), never ETFs.
I plan on TLH Vanguard’s VXUS (Vanguard Total International Stock ETF) for VEU (Vanguard FTSE All-World ex-US ETF).
At Vanguard will I be able to sell VXUS and buy VEU both in the same day, all while my settlement fund has a zero balance? or will I have to sell VXUS and wait until the settlement date then buy VEU leaving me at risk for a day or two?
Thanks! & great website!
p.s. please delete my duplicate reply under #6 above
hey dude as my same reply above, I’m not at same level as WCI or PoF, but yes, you should be able to sell an etf, then immediately will have the money available to buy another etf. Be careful for #9 in the post above- even seconds between these orders can means the difference between a percentage point or 2 change given the crazy volatility right now!
You don’t need to wait for settlement, but a true exchange will be easier on a less volatile day if you put the orders in at once. See # 9 above.
Great post Jim too bad this didn’t come out until I made mistake #9. I even submitted a speakpipe question regarding this, but is there anyway to avoid #9 with exchange ETF’s or mutual fund to ETF? Do any brokerages have the ability for you to put in an order to exchange ETF’s immediately without 2 separate orders?
Love the TLH love on this forum btw!
No.
Bummer 🙁
My next life I’m opening a brokerage that can do this!!!
We haven’t yet sold a business, but a couple of questions for the near future.
1. Where does tax loss harvesting stop? Or what are the guidelines under which you’d do it in the first place?
Something is always dropping in value. You could easily sell / exchange / TLH continuously and generate additional losses well beyond the $1,000 in tax savings from the churn and transaction fees. I’m curious about any guidelines that help prevent that from happening.
2. Does TLH help minimize taxes when selling a service business that didn’t issue stock?
Most business sale proceeds are taxed as regular income rather than assets or stock that would allow capital gains treatment. Partly because of how the business is structured, partly because no one want to buy potential skeletons when acquiring the business, partly because many business don’t own significant depreciable assets.
My current business happens to be a C Corp, but I can’t imagine anyone purchasing a majority of the stock and taking on additional liability. It’s more likely they’ prefer to transfer the assets to an existing entity or new entity without any operating history.
Thanks!
1. Why would it stop? I do it any time I have a loss.
2. Yes. Some of the capital gains are offset by your capital losses. Whether you sell the shares or the assets, there’s still a gain there.
Wait……there are no taxes on capital gains up to $80,000!?! I can’t believe I’ve never heard about this before. So if I wanted to live on $120,000 a year in retirement and I had a large taxable account and a Roth IRA/401k I could take $80,000 out of the taxable and $40,000 out of the Roth and pay $0 in tax? Am I understanding that correctly?
Yup. Welcome to the FIRE community. Wait until you find out about how ACA subsidies, the earned income credit, and food stamps work. 🙂
Thanks for another excellent post, WCI! Love the depth of knowledge explained with such clarity when you wade into the weeds.
Thank you for everything you do WCI. Love your work including the Fire Your Advisor Course.
In 2019 I took over investing from my advisor and converted to index funds then switched from FZILX to IXUS in my taxable account after reading about the tax benefits of ETFs. Now I am looking into TLH, but of course have read all the difficulties with TLH and ETFs. Given I use Fidelity (I know Vanguard mutual funds are better) do you think the ease of TLH with mutual funds outweighs the tax benefits of ETFs in your taxable account? Or are the ETF’s worth the hassle? How much of a tax benefit are you really getting from those ETFs? I reread some of your prior ETF articles, but couldn’t find a definitive answer. I am conflicted.
Thank you!
Hi Zach I too last year took over my finances from the captivity of a NWM financial “adviser” and now have a taxable at fidelity. b/c of TLHing lately I am in ETF’s.
I am not Jim but I would say that yes because of #9 above, the tax benefit of ETF’s just isn’t worth the hit you can get when TLHing in this volatile market. I sort of posted above I had #9 happen to me where just a few minutes of trying to put in the order for an ETF the market spiked up 2%!!! also an etf really is more beneficial tax wise if there is high turnover in the etf compared to it’s corresponding mutual fund, b/c the way an etf is more tax efficient is it’s unique ability to “flush out” capital gains when you sell stocks within the fund because it does not meet it’s criteria. For example, if a few companies suddenly drop out of the S&P, the S&P mutual fund will have to sell those companies likely creating a capital gain which you will be taxed on. However, the S&P 500 ETF can offset that gain to any losses from companies within the fund. I’m not sure why but mutual funds don’t have that ability.
IXUS and other total international stock index funds typically don’t have high turnover, given they are not buying and selling too much. More specific market sectors or asset classes will have higher turnover, even more than the S&P 500 I mentioned above. For example, a small cap value index fund turns over a lot given many companies will suddenly become mid cap or large cap or become more growth, so would make sense to do a small cap value index etf in your taxable vs. mutual fund. I myself only plan to have total stock market and total international in my taxable, so I am not sweatin having just mutual funds for the rest of my life and am actually planning on TLHing back into FZROX, and FZILX if the opportunity arises on June 2nd b/c unfortunately I violated fidelity’s roundtrip rules of buying and selling into fidelity mutual funds within a 30 day period, so need to wait 85 days.
Jim, please correct me if I am wrong in my explanation above. btw loved your interview on Bogleheads podcast with Rick Ferri. I too was banned from the Bogleheads forum, for promoting 1st Republic student loan refinancing. So whatever I will just post here 🙂
These are all pretty minor issues I suppose in the big picture. Yes, ETFs are probably worth the extra hassle in my opinion. But not by much.
Thanks Jim! I recently posted on the forum with a variation on this question. Timely, and very helpful, as always!
Hi Dr. Dahle,
We are a dual-resident household with plans for both of us to continue onto fellowship in a year. We are maxing out traditional 403(b) and IRA contributions such that our projected taxable income won’t exceed 80K for another 5 years. We were planning to let our ~$30K VTSAX taxable account grow and then convert to bonds just prior to owing capital gains taxes. Thoughts on the following strategy given the current situation?
– Tax-loss harvest for now
– If the market recovers in 5 years, trade VTSAX/ market equivalent for bonds prior to owing capital gains taxes as planned
– If market doesn’t recover in 5 years, we would have some TLH funds to make up some of the capital gains taxes we would owe when converting from VTSAX to bonds once the market does recover. In the interim, we get a few 100s knocked off our income for taxes each year
Is this too much work for a relatively small savings account given the expected market volatility over the next 5 years? Should we just leave the account as VTSAX and then tax gain harvest once the market recovers, adding bonds to the portfolio as our income increases?
Thanks for all your great work,
Melissa
Hi Melissa, I’m not Jim but have some thoughts as I just got financially literate and love to see where I can help. congrats on being just a resident and seemingly being financially literate already!!!! I was 7 years into attending hood before getting educated to well down and don’t buy whole life insurance like I did! also, what fellowship is 5 years??? cardiac electrophys? Holy Smoly
I was a little confused to why you would want to convert VTSAX into bonds in taxable? Is 100% VTASAX something you bought into before you had a financial plan? Or did the recent market volatility make you guys realize your risk tolerance is lower than you thought? Did you have as part in your financial plan on changing your asset allocation but not have enough room to maneuver in tax deferred accounts? Did you somehow need this money sooner than you thought, maybe for a house or something?
It really makes the most sense to change stocks to bonds in tax deferred accounts so that would be what I would recommend. Many bonds give off taxable income so usually it’s best to try and not have bonds in taxable (although Jim did write an article “Bonds in Taxable” but he was just really providing a counter argument only). You could go US treasury bond funds or even state specific muni bond funds if you don’t live in a tax free state, but yields are lower and state specific muni bond funds also increase risk.
My recommendation (though I’m not Jim) is to TLH VTSAX into another total stock market fund that tracks a different index. Still nice to take tax deductions and also give it a try for the first time with only a little bit of money on the line. I would not try and time the market as to when to convert stocks to bonds in your taxable account and time your lower overall taxable income. Just seems to complicated, and likely your best TLH opportunity would be now. Instead of tax gain harvesting down the road, I would actually take that IRA (it’s traditional, right) and do a Roth conversion before attending hood given you guys’ income will only be a little more than half of your attending salary and you will have the salary to cover any tax due. I would reallocate your asset allocation in tax deferred accounts, but given how the market has crashed your asset allocation has likely just converted itself to more bonds (assuming you have any). If no bonds in your portfolio, then I would use new contributions to buy bonds rather than selling stock indexes now given they are at rock bottom prices.
If that money in taxable was for a home purchase or something you would need in around 5 years, I would start saving for that now in a bond fund or money market account or cd with new contributions.
Thank you for your feedback. WCI has been instrumental towards becoming financially literate- and as an extension of this, to being able to have 2 kids while we’re both in training! To clarify:
1. We’re both pursuing fellowships as part of a physician scientist training program. Not the most lucrative/ efficient plan to financial independence, but it’s what we want to do 🙂
2. We were fine with VTSAX in taxable. Our strategy was to gradually convert to bonds as the stock portion of our portfolio grew in our retirement accounts. We were thinking bonds in taxable would be taxed less once we owe capital gains taxes since they grow slower (though I know this view is simplified and more nuanced per the WCI “bonds go in taxable” article). It would have been nice to have the account as a source of liquidity, but we aren’t relying on it as we anticipate having ~$200K equity in our townhome that we can use towards a downpayment for a new family home once we finish training.
3. We haven’t delved into muni’s yet, for some of the reasons outlined in a former WCI post: https://www.whitecoatinvestor.com/why-municipal-bonds-probably-dont-belong-in-your-portfolio/.
4. We are currently investing in traditional (vs Roth) IRA’s during training based on PoF’s analysis for a low 6-figure income household here: https://www.physicianonfire.com/lowsix/
2,3. Why not just add bonds in the 403b etc? If you do put bonds in taxable, you probably want muni bonds. Note that I’ve changed my opinion on munis pretty significantly since that post about munis was written.
4. I don’t think I agree with traditional for you at this stage unless you’re going for PSLF. I don’t think POF would either. The assumption in that linked article is that you’re low six figures and will stay there. That’s not the case for most docs in training.
Why are you converting to bonds? That’s an odd goal.
It’s also odd to tax loss harvest when you don’t owe capital gains taxes, but I guess $3000 against ordinary income a year is $3000 a year right?
Is there a reason you’re not doing Roth 403b and Roth IRA contributions? Are you trying to maximize the amount forgiven under PSLF or something?
Yes, it’s fine to add bonds at some point after training. Your taxable account itself is wealthier than our entire net worth upon leaving training.
3. I hadn’t seen the updates about muni bonds- thanks for bringing this to my attention! They will be a good option for our taxable account once we owe capital gains taxes.
4. Great point about POF’s analysis applying to those whose income will stay in the low six figures- I missed this point the first time around. Traditional rather than Roth will make a difference of ~$45K in taxes for us in training (in large part thanks to the EITC in the first couple years of training: https://frugalprofessor.com/etic-guest-post-on-gocurrycracker/). This difference may not be equivalent to the benefit of going with Roth’s now; I haven’t calculated the projected difference. Liquidity will be helpful as we are trying for a third child soon. We’d also prefer to have a downpayment on hand rather than as equity in our house. Also, traditional vs Roth now may make a negligible difference if we do sufficient Roth conversions in the future. We both plan on working full-time, being super savers during our peak earning years, not being super spenders in retirement, and possibly even retiring a little earlier.
Side note: this week, your tips on refinancing (from 30 year to 15 year fixed at 2.75% APR for us) will save us ~15K over the remaining 5 years of training. Thank you for your advice in this area, too!
Thanks for the encouragement. We will be in training (with the PhD and fellowships) for 7 years longer than most of our colleagues who take straighter paths thru medical school and a 3-year residency, so it is good to hear we’re doing ok financially 🙂 Regardless of the vehicle, we will continue to max out our tax-protected accounts during training. This will allow us to save ~0.5M in retirement savings by our mid-30s, a solid start for our young family.
I have a question around the 60-day qualified dividend rule – i.e., that you must hold the investment you’re using to tax loss harvest for at least 60 days (before or after) the ex-dividend date (i.e. when the dividend is paid). Are you saying you just need to own a single share in the investment for 60 days to ensure you’re safe? For example, if you harvest losses on shares of VTSAX that you’ve owned for years (harvesting into, say the 500 Fund), but you also recently bought additional shares in VTSAX 45 days ago that you’re not selling (either from dividend reinvestment or just regular purchasing), does that implicate this 60-day rule? I understand that dividend reinvestment might cause you to run afoul of the wash sale rule if you’re not careful, but it’s not clear how that may affect the 60-day rule.
No, I think you need to hold all the shares you owned at the time the dividend was paid.
In your second example of Wash sale:
Day 1: You buy 10,000 shares of Fund A for $100,000
Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares. You now have $180,00 and 20,000 shares of Fund A
Day 6: You exchange 10,000 shares of Fund A for Fund B.
You have no tax loss. This was a wash sale.
But if you set-up your share as FIFO (first in and first out), would the exchange of your old 10,000 shares of Fund A for Fund B qualify for tax loss? Thanks.
No- even if you are set up as FIFO, it still doesn’t qualify for tax losses. All shares purchased within the prior 30 days must be sold in order to avoid a wash sale.
I guess if I buy the cheap shares and keep for more than 30 days, then I do not have to sell those for TLH, meaning just sell the older/more expansive shares and buy cheaper same sector but different funds. Please comment. Thanks.
That’s right. No wash sale if you wait 30 days.
No. Because you bought new shares within 30 days of selling the old ones.
If I change your time-line to following, would that work as TLH?
Day 1: You buy 10,000 shares of Fund A for $100,000
Day 31: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares. You now have $180,00 and 20,000 shares of Fund A
Day 62: You exchange 10,000 FIFO shares of Fund A for Fund B.
Do you have tax loss of $10,000 (as you sold the older shares via FIFO) or just $5,000 loss (sold 50% of both older and newer shares even it was set-up as FIFO) or no loss at all due to wash sale? Thanks for clarify.
Yes. $10K loss.
In general, set it up as specified shares rather than FIFO, but same effect in this case.
On vanguard, do I have to sell my shares of a mutual fund than buy the different fund, or can I use the exchange function and it’ll still work. This would still be valid for tax loss harvesting?
Exchange is fine.
Hi Jim,
I am confused, you said ” I used $30,000 in losses in 2019 to offset a short term capital gain I felt was wise to realize, but more importantly, I own all or part of several highly appreciated small businesses that I expect to sell at some point prior to my demise. Up to half a million dollars from those sales will be tax-free.”
But I thought you could only use a maximum of $3000 per year from tax loss harvesting?
So how can you use $30,000 in one year?
Thank you
$3,000 per year against ordinary income. You can use an unlimited amount against capital gains.
2020 was my first year with a taxable account (with Fidelity), holding only ITOT and IXUS for broad tax-efficient index coverage. I’m interested in tax loss harvesting next time there’s a downturn, but I’m pretty nervous about #9 since right now I only hold ETFs. I guess this leads me to two questions…
1) When attempting to harvest a loss going from ETF to a mutual fund, is the same risk of price changes due to volatility present? I guess you can sell the ETF instantly and hold on to the cash for 30 days if the mutual fund were to shoot up in price, only buying it if it declined further, or setting a limit order at the time of ETF sale for the mutual fund at or below the prior day’s price. Would this protect me?
2) I’ve heard ETFs are more tax efficient than mutual funds (outside of Vanguard), but is this advantage more or less than that available from TLH? Would it be better to keep low cost mutual funds in my account (e.g. FSKAX, exchanging for FZROX or large-cap alternatives) and pay a little more in taxes to get an easier benefit from TLH?
Hi. Is it the case that you CANNOT own any of Fund B at the time you do the TLH? In other words, if you are going to exchange Fund A for Fund B is it okay if you already own shares in Fund B at the time you do the exchange? (Assuming you comply with all other timing requirements).
Yes, that’s fine.