By Dr. Jim Dahle, WCI Founder
One benefit of a market trending down is that an investor can get Uncle Sam to share in their losses by tax-loss harvesting. Up to $3,000 a year ($1,500 married filing separately) in net investment losses can be deducted from your regular income. In a typical physician tax bracket, that's worth about $1,000 in cold hard cash. If you have more losses than $3,000, the loss can be carried over and applied to your future tax bills.
For many people, it is hard to sell a losing investment. You have to admit you didn't have the ability to tell the future. Once you admit that your crystal ball is always cloudy, you realize that the intelligent investor can take advantage of the downturn.
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. You're still fully invested (and so haven't “sold low”) but still get to use the loss on your taxes.
How to Tax-Loss Harvest
I wrote about this in 2018 when describing how to tax-loss harvest through my Vanguard account (we also demonstrated how to do it with a Fidelity account). But here's a good rundown of how to think about it.
#1 Buy and Hold Investments You Want to Hold for a Long Time
If you're not jumping around in the market, market-timing, and speculating, then you've bought investments that you want to hold even if they go down temporarily.
#2 Harvest Losses in a Decline
When they decline in value, instead of panicking and just selling them completely, you “harvest the losses.”
#3 Trade for Something Similar
You get the tax benefits just for selling the losing investment. But if you don't trade it for something similar, you commit the cardinal investment sin of buying high and selling low. The wise investor SWAPS the losing investment for one that is highly correlated with it. The net effect is that your portfolio doesn't change substantially, yet you still get to claim the losses on your taxes. As an example: 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.
Need some help in figuring out which pairs you can swap? Here's an extensive guide on tax-loss harvesting pairs and partners.
Tax-Loss Harvesting Rules
There are a few important tax-loss harvesting rules.
Substantially Identical Rule
This means you could swap a Vanguard Total Stock Market Fund for a Vanguard 500 Index Fund, but you couldn't swap a Vanguard Total Stock Market Fund for a Vanguard Total Stock Market ETF. Those are substantially identical. Now, some people think the IRS really dives into the details of these transactions, but I don't know anybody who knows anybody who has ever been audited on this point. The IRS has bigger fish to fry. So, I really wouldn't spend any time worrying about it. Certainly, in this case, one fund holds thousands more stocks than the other, so it is an easy argument to make that they are not identical. You can also argue that two indices and the holdings themselves are different even if you're using a Total Stock Market fund from two different companies.
Wash Sale Rule
The easiest rule to screw up tax-loss harvesting is the wash sale rule. That means you can't turn around and buy the same security in the 30 days after you sell it—if you do, the basis is reset and that loss you were trying to get is washed away. You also can't buy it in the 30 days BEFORE you sell, UNLESS you also sell the shares you just bought. You also can't buy the same security in an IRA that you just sold in taxable. The tax code doesn't say you can't buy it in a 401(k), but I think that is at least against the spirit of the rules.
Be careful buying and selling frequently, of course. If you don't hold a security for at least 60 days around the dividend date, you will turn that dividend from a qualified dividend into a non-qualified dividend, eliminating a lot of the benefit of that tax loss.
60 Day Dividend Rule
Don't forget that owning a security for less than 60 days around (including before or after) a dividend date turns a dividend that would have otherwise been qualified into an unqualified dividend. You pay a much lower tax rate on qualified dividends than non-qualified dividends. So if you start frenetically tax loss harvesting, you could end up paying MORE in taxes. Slow it down, especially around dividend dates.
When to Do Tax-Loss Harvesting
In June 2018, there was a period of time where stocks dropped for about six days straight. There were similar episodes, at least for international stocks, in February, March, and May of that year, as well. If you had purchased an international stock index fund at any point during 2018, chances were very good by June 19 that you had a loss you could tax-loss harvest, especially if you had not already done it for that year. (Obviously the really astute probably already did this in February, March, or May.)
That's one example of when it would have been a good time to tax-loss harvest.
Remember, though, you're likely having to pay administrative costs whenever you're exchanging funds. You need to make sure that your tax gains will be higher than the costs you're having to pay.
An Example of Tax-Loss Harvesting
The Stock Purchase
On March 14, you bought $5,000 worth of Vanguard Total Stock Market Index Fund (TSM) at a price of $32.64 a share and $5,000 worth of Vanguard Total International Stock Market Index Fund at a price of $15.67 a share.
The Exchange
On Friday, August 5, you exchanged the TSM for Vanguard Large Cap Index Fund, selling the shares of TSM at $29.99 a share and exchanged the TISM for Vanguard FTSE Ex-US Index Fund, selling the shares of TISM at $14.66 a share.
The new funds have a correlation with the old funds of something close to 0.99. It's essentially identical for investment purposes. But per the IRS, the investments are not “substantially identical” for tax purposes.
Booked Loss
You have now booked a total loss of $728.22. Given a 32% federal tax bracket and a 5% state tax bracket, you've now saved yourself $728.22 × (0.32+0.05) = $269.44 in taxes. The best part is that if the market trends down, you can do it again tomorrow. You just have to remember not to go back to TSM and TISM for at least a month, or the “wash sale” rule eliminates your tax break.
The Critics
Some critics point out that you'll end up paying later the tax you save now because you've lowered your tax basis on the investment. That is true, but there are several reasons why it is still a good idea.
- First, there's a tax arbitrage here. You get to deduct taxes at your regular income tax rate, 37% in the example, but only have to pay at the capital gains tax rate later, say 15%.
- Next, there is a benefit to deferring the taxes as long as possible. Money now is worth more than money later—due to inflation and also due to the time value of money.
- Last, it's possible you'll NEVER have to pay taxes. If you later use the shares for a charitable donation (in which case neither you nor the charity pays the tax) or if you die and leave them to heirs (in which case there is a step up in basis to the value of the investment on the date of your death), then you'll never have to pay that tax.
Remember that you can only tax-loss harvest in a taxable account.
But if you do have a taxable account, the next time there is a downturn in the market, see if there is some tax-loss harvesting you can do. It won't necessarily allow you to FIRE tomorrow, but it could provide some nice tax savings.
What do you think? Do you tax-loss harvest investment losses? Why or why not?
[This updated post was originally published in 2019.]
I’m new to having a taxable account. To prepare to TLHing, would you say it’s better to use ETFs or mutual funds? I hold only mutual funds in our Roths and 401Ks, so they’re what I mostly know. From one of your articles and Booglehead’s I can see one advantage of ETFs is not having to wait to the end of the trading day to know the sale price like a mutual fund. Do you have a rec one way or the other? Thank you.
Either is fine. As the years go by, I tend to use ETFs more and more. When we’re talking about non-Vanguard funds, ETFs are generally more tax-efficient than funds.
https://www.whitecoatinvestor.com/mutual-funds-versus-etfs/
I actually find funds slightly easier to TLH because they are instantly swapped at 4 pm Eastern rather than requiring both a sell and a buy order to be put in sequentially.
I think I don’t understand the “last lot” exception to wash sales. In my Vanguard account, I sold Wellesley for a loss and bought Wellington to replace it on June 26. Then I decided that I just wanted to sell everything and leave my money in Vanguard’s money market fund since it was paying 5.23% interest. So on June 27, I sold everything (i.e. the Wellington) and put the proceeds in the money market after holding the Wellington for only a day. I figured that under the “last lot” rule, by selling everything and staying out of Wellington for the next 30 days I should be fine wash-sale-wise. I have stayed out and am still out of Wellington. But Vanguard insists on counting it as a wash sale. Who is right?
Both Vanguard and Fidelity sometimes flag these as “wash sales” but it’s inconsistent. It obviously makes zero sense to do so if you step back and think about it. If you buy something and sell it two days later for a loss you should be able to deduct the loss.
Is there any issue if you were to say have VTSAX in your 401k and/or Roth IRA, as well in a taxable account, then decided to TLH the VTSAX in taxable (since that is the only place you can do it) but still hold it in your other tax advantaged accounts? Lets assume two scenarios 1) You’ve already maxed out the tax advantaged accounts for the year, and 2) You will still be making contributions this year to the tax advantaged accounts but will wait 31 or more days after you TLH in the taxable. Mainly I guess the question is does it matter if you are holding the identical CUSIP in a tax advantaged account when you TLH, just making sure you do not buy it back too soon to avoid the wash sale.
First, the 401(k) is irrelevant. Only the IRA would affect possible wash sales.
Second, it’s okay to hold in the other account, it’s only buying and selling that matters, but that includes reinvesting dividends.
Hi Jim,
Curious on your thoughts on TLH around a dividend date. I have a few lots of VXUS down and dividend has not been paid yet. IXUS already paid the dividend. Would it be a good or bad idea to TLH to IXUS and not get the dividend for this quarter? If the dividend reduces the NAV by the amount of the dividend, it generates a taxable event but is net neutral from a price standpoint.
Thanks!
If you time it just right you could save a little. Probably not something I’d put a lot of effort into but yes, your approach could save some tax dollars.
Dr. Dahle,
What issues could I have by holding the C Fund inside a TSP? I’ve read C Fund tracks the S&P 500 index, and I’m forced to reinvest dividends. While I could request to change my investment allocation before TLH in a taxable account, I don’t have an option to sell recently purchased C Fund shares from the past 30 days.
I have VTI inside my taxable account but when it comes time to TLH, my plan was to sell VTI and buy VOO. I’m now concerned this might create a problem because of the C Fund. Can you make a recommendation ?
Are you worried about a wash sale? Those don’t apply to 401(k)s or the TSP. So quit worrying about that. Those are only an issue in IRAs and taxable accounts.
VOO is a reasonable TLH partner for VTI, but I think ITOT is better. That’s what I use.