Tax-Loss Harvesting

One useful thing you can do with your portfolio during market declines is 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 24% tax bracket. At the beginning of the year, Mary bought $100,000 of Vanguard Total International Stock Index Fund in her taxable account. And let’s imagine that 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. And Mary would use the proceeds from the sale to purchase another fund to serve as a replacement in her portfolio.

Mary can use the $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 reducing her income tax by $720 (i.e., $3,000 x 24%). 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).

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 24% (because she’s in the 24% tax bracket). When she sells the replacement fund, the long-term capital gain will be taxed at a lower rate (likely 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.

Potential Pitfall: The Wash Sale Rule

The place where people often trip up is by accidentally triggering the “wash sale” rule. A wash sale occurs when you:

1. Sell an investment for a loss, and
2. Buy “substantially identical” securities within 30 days before or after the sale.

When a wash sale occurs, the loss is disallowed. Fortunately, the cost basis of your new shares is adjusted upward by an amount equal to the disallowed loss so that when you sell the shares in the future — assuming you don’t trigger the wash sale rule yet again — you’ll be able to claim the loss (or, depending on circumstances, a smaller capital gain).

Example: Catherine buys 100 shares of a stock at $38 per share. A few months later, Catherine sells the shares for $25 per share. Five days later, she buys another 100 shares of the same stock at $29 per share. Because she bought new shares within 30 days of the sale, the wash sale rule will be triggered, and Catherine’s loss of $13 per share will be disallowed. Her cost basis in the new shares, however, will be $42 per share ($29 purchase price + $13 from the disallowed loss), thereby allowing for a larger capital loss or smaller capital gain when she sells the shares in the future.

Wash Sales Due to a Spouse’s Transactions

Some investors hope to avoid the wash sale rule by having their spouse buy a particular investment at the same time that they sell it for a loss. But, as explained in IRS Publication 550, this does not work. For the purpose of triggering a wash sale, your spouse buying or selling an investment has the same effect as you buying or selling the investment.

Wash Sales Due to Buying in an IRA

Other investors try to avoid a wash sale by selling an investment for a loss in their taxable account, then buying the same investment in their IRA — with the idea being that the IRA is titled differently than the taxable account, so it would not trigger a wash sale.

This doesn’t work either. Buying a “substantially identical” investment in your IRA (whether Roth or traditional) within 30 days of the sale will result in a wash sale.

Wash Sales Due to Buying Within 30 Days Prior to Sale

Finally, many investors think of wash sales as only occurring if you re-buy the investment shortly after selling it. That is, they forget that a wash sale can occur if you buy shares within 30 days prior to the sale.

Example: On January 1, Josh buys 100 shares of Vanguard Total Stock Market ETF in his brokerage account for $60 per share. On January 15, Josh buys another 100 shares for $58 per share. On January 20, Josh sells 100 shares, at a price of $56 per share. Josh has a wash sale. His loss will be disallowed and added to the cost basis of his remaining 100 shares.

Note, however, that you do not need to worry about wash sales if you liquidate all of your shares of a given investment and you do not repurchase substantially identical securities within 30 days.

Example: On January 1, Lucy buys 100 shares of Vanguard Total Stock Market ETF in her brokerage account, at a price of $60 per share. On January 10, Lucy sells her 100 shares for $55 per share, and she does not purchase substantially identical securities in any of her accounts within the next 30 days. Lucy will be able to claim her loss of $5 per share, despite the fact that a purchase occurred within 30 days prior to the sale.

Wash Sales from Buying in a 401(k)

Update: A few readers asked whether a wash sale can be triggered when, after selling an investment for a loss in a taxable account, substantially identical securities are purchased in a 401(k) or 403(b).

This answer is a bit trickier. 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.

What Makes Two Mutual Funds “Substantially Identical”?

Update #2: Several readers also wrote in with questions about how to know whether two mutual funds are “substantially identical” for the purposes of triggering a wash sale.

Unfortunately, I’m not aware of any official IRS position providing a cut-and-dried test to determine whether two mutual funds are substantially identical. From what I gather, challenging people on the wash sale rule is just not a top priority from a tax enforcement standpoint.

Personally, my standard is this: If the IRS did challenge my position, and I ended up in court having to make the case that these two funds were not substantially identical, would I feel confident about my chance of success? Unless the answer is “yes, absolutely,” I’d choose a different (less similar) mutual fund.

For example, I would not be comfortable making the case that the following are not substantially identical:

• The ETF version and the mutual fund version of a given Vanguard index fund,
• Two index funds or ETFs that track the same index (even if their holdings are not identical), or
• Two “total market” index funds, even if they track slightly different indexes.

In short, I would probably not want to use a given fund as a tax loss harvesting partner for another fund unless I could not only show that the underlying portfolios are different, but also provide a chart showing that the two funds really do perform noticeably differently. But, as with the previous question, this is one in which other people could rationally reach a different conclusion.

Finally, as author Taylor Larimore often reminds investors at the Bogleheads forum: If you want to tax loss harvest with a particular fund, and you don’t want to worry about finding a replacement fund that’s similar but not substantially identical, you can always just wait 31 days after the sale, then re-buy the original fund.