The White Coat Investor Network[Editor's Note: Today's WCI Network post is from the Physician on FIRE and is about getting Uncle Sam to share in your losses by tax loss harvesting.]

Whenever the stock market loses at least 10% of its value, as it does most years, those of us with taxable brokerage accounts have an opportunity to lower our tax bills.

Tax loss harvesting (TLH) is a simple maneuver. You’re selling one asset and buying another. However, it’s often misunderstood and not done in an ideal manner. The tax loss harvesting tips that follow should answer some of your questions and help you make these transactions confidently.

I’ve harvested something close to $300,000 in losses over the past six or seven years. February and March of 2020 were particularly fruitful. At this point, if I realized no capital gains, I could use my accumulated paper losses to offset $3,000 of earned, ordinary income for the rest of my life and then some.

However, sometimes I realize capital gains, like when I sold some lakefront property in 2020, taking a high five-figure gain that will take away a chunk of my carried-over losses.

I also had a microbrewery investment go full-circle in 2020, and I realized more capital gains there. We’ll also be selling our $90,000 house for a significant gain in 2021. In all of these cases where capital gains are realized, my prior losses from TLH efforts will ensure that I don’t owe any taxes on the newly realized gains.

You never know when it might be helpful to have some pocketed losses, so I’m always on the lookout for another TLH opportunity.

 

Top 5 Tax Loss Harvesting Tips

I’d like to dispel some myths and offer some tips to make tax loss harvesting (TLH) easier and more effective. If you’re new to the concept, I consider the following posts, particularly the Vanguard guide, to be prerequisites.

Please read these first as they’re actually chock full of tips, also, along with screenshots that show you exactly what to do.

And, from WCI:

Briefly, tax loss harvesting is a way to book losses without being out of the market for any significant time and without a substantial change to your asset allocation.

You do this by selling one asset, say a total stock market fund like VTSAX/VTI and simultaneously or shortly thereafter purchasing one that would be expected to perform similarly.

In this case, an S&P 500 fund like VFIAX / VOO could work. No, it doesn’t have the extended market (mid-caps and small caps) that the total market fund does, but its performance is going to be very similar. The correlation between the two funds’ return is 99%.

TLH is a quick and easy way to save $1,000 or more on your annual tax bill and potentially save a whole lot more if you can offset large realized capital gains in the future. The following are my top five tips and clarifications, along with some bonus tips at the end.

 

#1 Take a Big Enough Loss

I generally like to see a four-figure loss before pulling the TLH trigger. You’ll notice that in my Vanguard example, I took a loss for under $1,000. Why? Mainly because I wanted to put together the post and I took the first opportunity that came along to demonstrate a loss.

It does take a bit of time and energy to TLH, and it means buying something that you didn’t initially own. It makes having a true three-fund portfolio extremely difficult. I wouldn’t do it to take a loss of dozens or a few hundred dollars.

However, any time you can take a loss of at least $1,000, I say go for it. That’s a 10% loss on a $10,000 investment or a 2% loss on a $50,000 investment.

 

#2 Buy Something You’d Be Comfortable Owning Forever

Here’s a dilemma I’ve heard from investors who successfully tax loss harvested but then felt stuck. They had exchanged into a fund they weren’t comfortable keeping.

Don’t do that.

What can happen and frequently does happen is a swift rebound in the stock market after you’ve made an exchange. If the market is up a month later, you can’t trade back to your original holding (the asset you sold) without realizing some capital gains and at least partially canceling out the paper losses you previously booked.

My advice is to never purchase something you wouldn’t be comfortable owning indefinitely.

An exception can be made for generous souls who donate appreciated assets to charity. That’s one way to part with an asset you might consider to be suboptimal in your portfolio.

 

#3 You CAN Sell Something You Just Bought

This isn’t so much a tip as it is a clarification of the wash sale rules. A wash sale occurs when you purchase or have purchased a “substantially identical” asset to the one you sold for a loss in the 30 days before and after the sale (or the day of the sale).

That’s a 61-day window in which you cannot have purchased “replacement shares” for the ones you sold.

So, if you purchased some VTSAX less than 30 days ago, can you sell it now and claim a loss? Yes, you can, as long as you sell all VTSAX purchased in the prior 30 days at the same time. If you’re making weekly or biweekly purchases as some people like to do, you can sell each lot at a loss.

If you have multiple newly-purchased lots and some of them have gains while the others have losses, you still have to sell all lots purchased in the last 30 days to avoid a wash sale.

A wash sale isn’t the end of the world, though. Here’s what happens, as illustrated on the Bogleheads Wiki:

“For example, you bought 100 shares of a mutual fund at $40. On March 1, you sold 100 shares at $30. On March 10, you bought 100 shares at $35. Your sale on March 1 was a wash sale, so you could not deduct the $1,000 loss at the time, but your basis in the March 10 shares is $4,500, not $3,500, so you will reduce your capital gains or increase your losses when you sell those shares.”

Also, most wash sales are only partial wash sales. This can happen if you automatically reinvest dividends or have automated investments into a retirement account.

If you sold 100 shares at a loss and bought 10 shares within 30 days, you can take the loss on 90 shares and the cost basis of the 10 newly purchased shares would be adjusted.

 

#4 You Are NOT Locking in a Loss

Again, this is more of a clarification. Any time TLH is brought up in a public forum like a personal finance Facebook Group, someone (usually a few people) will chime in that they’re buy-and-hold investors or that one should never sell low.

I don’t consider tax loss harvesting to be violating either of those principles.

I buy and hold an asset class. If I happen to bounce back and forth between Vanguard’s Total International Stock Index Fund (VTIAX) and their All-World ex-US Fund (VFWAX) with an instantaneous exchange at the end of the trading day, I remain fully invested. I’m just invested in a slightly different but not substantially identical fund in the same asset class.

You’re definitely not locking in an actual loss unless you only sell and choose not to buy a similar asset. If you do, that’s not really tax loss harvesting. That’s just a losing investment strategy, although it’s better to sell for something than nothing.

Index funds, unlike individual stocks, however, are not really at risk of going to zero. If they actually do become worthless, I imagine we’ll have larger worries than our investment account balances. Like how much canned food we have in the bunker. Or how to defeat the alien visitors.

 

#5 Consider a Series of Tax Loss Harvesting Partners

Tax loss harvesting can feel a bit like market timing, and in some ways, it is. You’re hoping to sell when the market has hit rock bottom.

I got lucky selling at the post-Brexit vote trough and again on Christmas Eve in 2018, but the timing on those trades was pure luck.

Sometimes, you’ll harvest some losses only to watch the market drop further. Now you have a newly-purchased fund with a loss but you can’t trade back into the fund you just sold for 30 days.

This is where a third fund, and maybe a fourth or additional funds can be helpful.

When we talk about tax loss trading partners, we’re talking about funds that are similar but not identical. There are gray areas here, as the IRS has not given guidance as to what exactly constitutes a “substantially identical” fund. All you will find online are opinions. They may be expert opinions, but they’re still just someone’s best-educated guess.

Personally, I would avoid trading two funds that are different share classes of the same fund (VTSAX to VTSMX) or the ETF to mutual fund with identical holdings (VTSAX to VTI). I also wouldn’t try tax loss harvesting from one fund to another that tracks the exact same index, like the S&P 500.

There are people who disagree, and that’s fine. If a gray area is easy enough to avoid, I try to avoid it.

Back to using a series of tax loss trading partners.

Say you sold VTSAX (total stock market) and bought the S&P 500 fund. Now that fund has a loss. You could trade it for a third fund. The Large Cap fund, VLCAX, could do the trick.

What if that fund has losses and 30 days isn’t up?

You could choose another large cap fund like Large Cap Growth or Large Cap Value. Don’t forget about rule #2, though—only buy what you’d be willing to hold indefinitely, and our holdings are getting more different from the original fund, especially with the value fund, and the expense ratio has also risen.

A better alternative might be buying a fund from a different brokerage. Both Schwab and Fidelity have total stock market funds that follow a different index than VTSAX.

  • VTSAX tracks the CRSP US Total Stock Market Index
  • SWTSX (Schwab) tracks the Dow Jones US Total Stock Market Index
  • FSKAX (Fidelity) also  tracks the Dow Jones US Total Stock Market Index
  • FZROX (Fidelity Zero Fee) tracks a proprietary index used only by Fidelity

Those are a few options and you can always use the ETF versions of funds when they exist. But again, I personally would not trade from one mutual fund to its corresponding ETF or vice versa and expect to book those losses.

I’ve also played this game with the international funds in my taxable account. Several years ago, I jumped from All-World ex-US to Total International to Developed Markets + Emerging Markets and swapped Developed Markets for the European and Pacific Stock Index funds.

That last trade probably violated my 2nd tip about only buying what you intend to keep, but the market dropped some more eventually, and I was able to get back to my original position in the Ex US fund with one last TLH exchange.

 

Bonus Tips

Avoid owning the same asset classes in your IRA as you have in your taxable brokerage account. This way, automated reinvestment of dividends can never create a wash sale. I have a REIT fund, a mid-cap fund, and a small-cap fund in my Roth IRA.

Turn off automatic dividend reinvestment in your taxable brokerage account. Reinvest manually, instead. Most funds pay dividends quarterly; I only have to do this four times a year.

Set your cost basis to show the basis of individual lots. If possible, do this after you buy, rather than when you’re ready to sell. Vanguard calls this “Specific ID”. With Fidelity, it’s “Specific Shares”.

Vanguard Cost Basis
Vanguard specific identification

 

 

Fidelity specific shares

 

Understand that your spouse’s accounts can create wash sales. Some couples keep much of their finances separate, but for the purpose of tax loss harvesting, you should have some idea of what he or she has in a brokerage account or IRA. Wash sales can result from purchases in those accounts. The same is true of purchases in an investment account of a business you own.

Know that there’s a 60-day qualified dividend rule as The White Coat Investor points out. If you hold a fund for less than 60 days and it pays a dividend during that time, it will be an ordinary, non-qualified dividend taxed at ordinary income rates. The consequence is probably trivial unless you take a very small percentage loss on a very large sum of money, but it’s worth mentioning.

Let someone else do it. If you’d like the benefit but are overwhelmed by the practical application of it, a roboadvisor like Betterment will use an algorithm to automate the process and do it for you. Their total investment management fees run about 0.25% per year, which could negate the benefit of tax loss harvesting for high net worth individuals.

 

What About 401(k)s? 403(b)s? 457(b)s? HSAs???

I don’t know. No one does.

The fact that no one seems to know for sure would indicate that no one is aware of the IRS calling someone out on a wash sale resulting from a purchase in any of these accounts.

It’s also worth pointing out that your taxable brokerage account most likely doesn’t see what happens in these other accounts. It would be on you to report any such wash sale.

Here’s what the Bogleheads have to say about the issue:

“The IRS has not specifically ruled that other tax sheltered accounts, such as 401(k) or 403(b) accounts, are exempt from wash sale rules.”

Mike Piper, the Oblivious Investor, says this in his post on the topic.

“Section 1091 of the Internal Revenue Code is the law that creates the wash sale rule. It doesn’t mention retirement accounts at all. The rule about wash sales being triggered from purchases in an IRA comes from IRS Revenue Ruling 2008-5. If you read through the ruling, you’ll see that it speaks specifically to IRAs and does not mention 401(k) or other employer-sponsored retirement plans.

To the best of my knowledge, there is no official IRS ruling that speaks specifically to wash sales being created by a transaction in a 401(k). In other words, I’m not aware of any source of legal authority that clearly says that a purchase in a 401(k) would trigger a wash sale.

However, in my opinion, it seems pretty clear that the line of reasoning in the above-linked revenue ruling would apply to employer-sponsored retirement plans as well as IRAs.

So, personally, I would not be comfortable taking a position on a tax return that’s based on the assumption that purchases in a 401(k) cannot trigger a wash sale. But that’s just my personal opinion. Others may disagree.”

If you read the whole post, he also says he would not be comfortable defending two different total stock market funds from different companies that track different indices as anything other than substantially identical. In other words, he would not tax loss harvest from VTSAX to SWTSX to FZROX. It’s another gray area, but one I’d personally be more comfortable with.

Regarding the HSA, again there is no clear guidance, but not many people would insist you could create a wash sale with a purchase there. But if you want to be exceedingly careful, it is another potentially gray area that can be avoided. I simply own a total bond fund in mine.

 

Tax Loss Harvesting Infographic

 

I hope these tips give you the power to tax loss harvest on your own. If you have questions about the actual process of buying and selling, it will look different on every platform, but, these guides may be helpful:

Do you have additional tax loss harvesting tips or questions? Leave them below!