Tax loss harvesting: Difference between revisions

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'''Tax loss harvesting''' is a technique to improve the after-tax return of your taxable investments.
'''Tax loss harvesting''' is a technique to improve the after-tax return of your taxable investments.


== Overview ==
== Overview ==
An advantage of taxable accounts is the ability to use the losses that inevitably occur in some years to lower your tax bill. This is called tax loss harvesting. There are three benefits. First, tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die. Second, after offsetting realized gains, you can use any remaining tax losses to deduct $3,000 from your regular income taxes each year, which can mean an extra $750 or more in your pocket if you are in the 25 percent federal tax bracket. Third, any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.
An advantage of taxable accounts is the ability to use the losses that inevitably occur in some years to lower your tax bill. This is called tax loss harvesting. There are three benefits. First, tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die. Second, after offsetting realized gains, you can use any remaining tax losses to deduct $3,000 from your regular income taxes each year, which can mean an extra $750 or more in your pocket if you are in the 25 percent federal tax bracket. Third, any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.


Suppose that you had invested $10,000 into a mutual fund in a taxable account and that with the steep decline in 2008, your holdings are now worth only $6,000. Since you plan to continue holding that fund, you might be inclined to ignore the losses and wait for the fund to eventually recover. Instead, using tax loss harvesting, you'd sell the fund, and then buy it back 31 days later. In the meantime, you can either hold the cash in a money market fund, or invest it in a similar but not identical fund. This has the effect of booking a $4,000 capital loss, while returning you to your original position 31 days later.
Suppose that you had invested $10,000 into a mutual fund in a taxable account and that with the steep decline in 2008, your holdings are now worth only $6,000. Since you plan to continue holding that fund, you might be inclined to ignore the losses and wait for the fund to eventually recover. Instead, using tax loss harvesting, you'd sell the fund, and then buy it back 31 days later. In the meantime, you can either hold the cash in a money market fund, or invest it in a similar but not identical fund. This has the effect of booking a $4,000 capital loss, while returning you to your original position 31 days later.


The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you can apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over (in this case, $1,000, which is the $4,000 in losses minus the $3,000 deduction), can be carried forward indefinitely into future years. Each year, you get to first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.
The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you must apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over (in this case, $1,000, which is the $4,000 in losses minus the $3,000 deduction), must be carried forward indefinitely into future years. Each year, you must first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.<ref group="note">Tax loss carryover to the following year is mandatory. See this {{Forum post | t= 318312 | title = If you TLH, do you have to apply it that tax year? | author = geospatial | date = June 22, 2020 }}.</ref>


Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. (In our example, you will owe more capital gains taxes in the future because you bought back the fund at a cost basis that is $4,000 lower.) However, because future money is worth less than money today, there's a saying in public finance that "a tax deferred is a tax avoided". Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you (and your spouse) are still holding the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the extra capital gains you owe in the (possibly distant) future will be at the (lower) capital gains rate, while the benefit you receive today of the $3,000 deduction is at your (higher) marginal income tax rate.
Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. (In our example, you will owe more capital gains taxes in the future because you bought back the fund at a cost basis that is $4,000 lower.) However, because future money is worth less than money today, there's a saying in public finance that "a tax deferred is a tax avoided". Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you (and your spouse) are still holding the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the extra capital gains you owe in the (possibly distant) future will be at the (lower) capital gains rate, while the benefit you receive today of the $3,000 deduction is at your (higher) marginal income tax rate.
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* '''[[Wash sale]]'''.  If you sell Total Stock Market with losses and buy back the same fund within 30 days before or after the sale, that would be called a wash sale, and you cannot claim the losses on your tax return.  The definition of a wash sale is a bit more complicated than that.  Before you do tax loss harvesting, be sure to familiarize yourself with the [http://www.fairmark.com/capgain/wash/ wash sale rule].
* '''[[Wash sale]]'''.  If you sell Total Stock Market with losses and buy back the same fund within 30 days before or after the sale, that would be called a wash sale, and you cannot claim the losses on your tax return.  The definition of a wash sale is a bit more complicated than that.  Before you do tax loss harvesting, be sure to familiarize yourself with the [http://www.fairmark.com/capgain/wash/ wash sale rule].
* '''[[Qualified dividend|Qualified dividends]]'''.  If you hold shares less than 61 days and receive qualified dividends from those shares, they are not qualified dividends even though the fund company may claim to be qualified dividends. See [http://www.fairmark.com/mutual/ordinary.htm Mutual Fund Ordinary Dividends] for more details.  Disqualification of qualified dividends may outweigh the benefit of tax loss harvesting in some cases.
* '''[[Qualified dividend|Qualified dividends]]'''.  If you hold shares less than 61 days and receive qualified dividends from those shares, they are not qualified dividends even though the fund company may claim to be qualified dividends. See [https://fairmark.com/investment-taxation/mutual-fund-tax-guide/ordinary-dividends/ Mutual Fund Ordinary Dividends] for more details.  Disqualification of qualified dividends may outweigh the benefit of tax loss harvesting in some cases.
* '''Loss on mutual fund shares held 6 months or less'''.  If you sell shares of a mutual fund at a loss, and those shares have been held for 6 months or less, then there are special rules that may alter the loss you claim. First, if those shares produced any tax-exempt interest, then the loss is reduced, dollar for dollar, by that interest. Second, if those shares were held while the fund distributed (long term) capital gains, then the loss is treated as a long term loss up to the dollar amount of the distribution those shares produced.<ref>[http://www.irs.gov/publications/p550/ch04.html#en_US_2014_publink100010540 Publication 550 (2014), Investment Income and Expenses], "Loss on mutual fund or REIT stock held 6 months or less," Viewed September 02, 2015</ref><ref>[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=173117 Corrections for the wiki article on TLH], forum discussion.</ref> Note that most Vanguard Tax Exempt funds (and others like them) are not subject to the preceding 6 month rule because of the way they accrue and pay out interest (dividends). The 6 month rule for tax exempt interest comes from 26 U.S. Code § 852(b)(4)(B), but there is an exception in 852(b)(4)(E) for funds that declare dividends daily and pay them monthly or more frequently.<ref>[https://www.bogleheads.org/forum/viewtopic.php?t=174363#p2634098 Re: Yield on Vanguard Int. Term Tax Exempt Fund], forum discussion.</ref> <ref>[https://www.law.cornell.edu/uscode/text/26/852 26 U.S. Code §852] law.cornell.edu.</ref>
* '''Loss on mutual fund shares held 6 months or less'''.  If you sell shares of a mutual fund at a loss, and those shares have been held for 6 months or less, then there are special rules that may alter the loss you claim. First, if those shares produced any tax-exempt interest, then the loss is reduced, dollar for dollar, by that interest. Second, if those shares were held while the fund distributed (long term) capital gains, then the loss is treated as a long term loss up to the dollar amount of the distribution those shares produced.<ref>[http://www.irs.gov/publications/p550/ch04.html#en_US_2014_publink100010540 Publication 550 (2014), Investment Income and Expenses], "Loss on mutual fund or REIT stock held 6 months or less," Viewed September 02, 2015</ref><ref>[https://www.bogleheads.org/forum/viewtopic.php?f=10&t=173117 Corrections for the wiki article on TLH], forum discussion.</ref> Vanguard, and likely most other brokerages, will not make the correct adjustment on your IRS Form 1099-B, so you will have to correct it yourself by filing Form 8949 and changing the type of capital loss.<ref>[https://www.bogleheads.org/forum/viewtopic.php?f=2&t=273200 TLH holding period not met for LTCG distributions; how to report?], forum discussion.</ref>
 
:Note that most Vanguard Tax Exempt funds (and others like them) are not subject to the preceding 6 month rule because of the way they accrue and pay out interest (dividends). The 6 month rule for tax exempt interest comes from 26 U.S. Code § 852(b)(4)(B), but there is an exception in 852(b)(4)(E) for funds that declare dividends daily and pay them monthly or more frequently.<ref>[https://www.bogleheads.org/forum/viewtopic.php?t=174363#p2634098 Re: Yield on Vanguard Int. Term Tax Exempt Fund], forum discussion.</ref> <ref>[https://www.law.cornell.edu/uscode/text/26/852 26 U.S. Code §852] law.cornell.edu.</ref>
:However, [[Exchange-traded funds | ETF]]s and the [https://personal.vanguard.com/us/funds/snapshot?FundId=1491&FundIntExt=INT|Vanguard Tax-Exempt Bond Index Fund] (which is the mutual fund class of an ETF) ''are'' subject to the six-month rule, because they declare dividends monthly, not daily.  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.
:However, [[Exchange-traded funds | ETF]]s and the [https://personal.vanguard.com/us/funds/snapshot?FundId=1491&FundIntExt=INT|Vanguard Tax-Exempt Bond Index Fund] (which is the mutual fund class of an ETF) ''are'' subject to the six-month rule, because they declare dividends monthly, not daily.  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.
*'''Death of taxpayer'''. Capital losses cannot be carried over after a taxpayer's death. They are deductible only on the final income tax return filed on the decedent's behalf. ([http://www.irs.gov/publications/p544/ch04.html#en_US_publink100072659 IRS pub 544]).
*'''Death of taxpayer'''. Capital losses cannot be carried over after a taxpayer's death. They are deductible only on the final income tax return filed on the decedent's behalf. ([http://www.irs.gov/publications/p544/ch04.html#en_US_publink100072659 IRS pub 544]).
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* '''Commissions and [[bid/ask spread]]s'''.  If you are doing tax loss harvesting on ETFs and/or individual stocks, you may have to pay commissions and bid/ask spreads, and they reduce the amount of money you get from tax loss harvesting.  For this reason, you may want to compare the amount of tax you save and the trading costs and do tax loss harvesting only when the trading costs are minimal compared to the savings in the current tax liability.
* '''Commissions and [[bid/ask spread]]s'''.  If you are doing tax loss harvesting on ETFs and/or individual stocks, you may have to pay commissions and bid/ask spreads, and they reduce the amount of money you get from tax loss harvesting.  For this reason, you may want to compare the amount of tax you save and the trading costs and do tax loss harvesting only when the trading costs are minimal compared to the savings in the current tax liability.
* '''Mutual funds'''.  You don't have a problem with commissions or bid-ask spreads.  However, some mutual funds have [[Redemption fee | redemptions fees]] for a certain period after the purchase. Another problem is that you could try to realize a small loss in a mutual fund position, but the loss may disappear by the time the redemption is processed.  For this reason, you may want to do tax loss harvesting on a sizable loss that's unlikely to disappear in one day.
* '''Mutual funds'''.  You don't have a problem with commissions or bid-ask spreads.  However, some mutual funds have [[Redemption fee | redemptions fees]] for a certain period after the purchase. Another problem is that you could try to realize a small loss in a mutual fund position, but the loss may disappear by the time the redemption is processed.  For this reason, you may want to do tax loss harvesting on a sizable loss that's unlikely to disappear in one day.
* '''Frequent-trading restrictions'''.  Vanguard does not allow you to sell most funds and buy back into the same fund electronically within 60 days. If you plan to buy the fund back in 31 days, one of the two transactions must be done by mail.   
* '''Frequent-trading restrictions'''.  Vanguard does not allow you to sell most funds and buy back into the same fund electronically within 30 days.<ref group="note">There are some exceptions. See: [https://personal.vanguard.com/us/whatweoffer/overview/exchangepolicy Vanguard Exchange policy]</ref> If you plan to buy the fund back in 31 days, one of the two transactions must be done by mail.   
* '''Volatility of investment'''.  In the real world, a tax loss harvester waiting  31 days to reinvest will see volatility in the investment. If the price of the investment goes up while the investor is on the sidelines she is disadvantaged; if the price goes down, she is advantaged. One might expect that over a long period of tax harvesting these volatility effects might wash out (if random) or perhaps, if there is a short term momentum effect, a slight advantage to the loss harvester over the long haul. This volatility of reinvestment risk can be mitigated if one immediately purchases a similar, but not substantially identical investment, but this comes with a higher degree of complexity especially if one is swapping fractional lots of the original fund.
* '''Volatility of investment'''.  In the real world, a tax loss harvester waiting  31 days to reinvest will see volatility in the investment. If the price of the investment goes up while the investor is on the sidelines she is disadvantaged; if the price goes down, she is advantaged. One might expect that over a long period of tax harvesting these volatility effects might wash out (if random) or perhaps, if there is a short term momentum effect, a slight advantage to the loss harvester over the long haul. This volatility of reinvestment risk can be mitigated if one immediately purchases a similar, but not substantially identical investment, but this comes with a higher degree of complexity especially if one is swapping fractional lots of the original fund.


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==Notes==
<references group="note"/>


==See also==
==See also==
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==External links==
==External links==
*{{Forum post|t=172568 |title=TLH for absolute dummies <nowiki>[Tax Loss Harvesting]</nowiki>}}, Aug 26, 2015. A "How to" guide for tax loss harvesting. Step 4 of the first post contains a sample list of comparable funds.
*{{Forum post|t=261874 |title=PhysicianOnFire blog: "Tax Loss Harvesting with Vanguard: A Step by Step Guide"|date=Oct 20, 2018|author=Taylor Larimore}}
*{{Forum post|p=2610557 |title=TLH for absolute dummies <nowiki>[Tax Loss Harvesting]</nowiki>}}, Jan 18, 2016. A "How to" guide for tax loss harvesting. Step 4 of the first post in that thread contains a sample list of comparable funds.
*{{Forum post|t=179414 |title=Real-life, real-time wash sale & TLH documented}}, Dec 12, 2015. A tutorial which includes screen shots and explanations of ''allowed'' and ''disallowed'' losses.
*{{Forum post|t=179414 |title=Real-life, real-time wash sale & TLH documented}}, Dec 12, 2015. A tutorial which includes screen shots and explanations of ''allowed'' and ''disallowed'' losses.
*[http://www.fairmark.com/mutual/stcl.htm Short-Term Capital Losses], Kaye A. Thomas, [http://fairmark.com/ Fairmark.com], viewed September 02, 2015.
*[http://www.fairmark.com/mutual/stcl.htm Short-Term Capital Losses], Kaye A. Thomas, [http://fairmark.com/ Fairmark.com], viewed September 02, 2015.

Revision as of 10:39, 7 February 2021

Tax loss harvesting is a technique to improve the after-tax return of your taxable investments.

Overview

An advantage of taxable accounts is the ability to use the losses that inevitably occur in some years to lower your tax bill. This is called tax loss harvesting. There are three benefits. First, tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die. Second, after offsetting realized gains, you can use any remaining tax losses to deduct $3,000 from your regular income taxes each year, which can mean an extra $750 or more in your pocket if you are in the 25 percent federal tax bracket. Third, any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.

Suppose that you had invested $10,000 into a mutual fund in a taxable account and that with the steep decline in 2008, your holdings are now worth only $6,000. Since you plan to continue holding that fund, you might be inclined to ignore the losses and wait for the fund to eventually recover. Instead, using tax loss harvesting, you'd sell the fund, and then buy it back 31 days later. In the meantime, you can either hold the cash in a money market fund, or invest it in a similar but not identical fund. This has the effect of booking a $4,000 capital loss, while returning you to your original position 31 days later.

The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you must apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over (in this case, $1,000, which is the $4,000 in losses minus the $3,000 deduction), must be carried forward indefinitely into future years. Each year, you must first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.[note 1]

Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. (In our example, you will owe more capital gains taxes in the future because you bought back the fund at a cost basis that is $4,000 lower.) However, because future money is worth less than money today, there's a saying in public finance that "a tax deferred is a tax avoided". Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you (and your spouse) are still holding the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the extra capital gains you owe in the (possibly distant) future will be at the (lower) capital gains rate, while the benefit you receive today of the $3,000 deduction is at your (higher) marginal income tax rate.

How it works

Tax loss harvesting works in several different ways.

Investing a single sum

January 2008: You invest $10,000 in Total Stock Market.

February 2008: The balance drops to $9,000. You sell it.

March 2008: You put $9,000 back into Total Stock Market. (Suppose that the share price is the same as in February, 2008 for simplicity.)

February 2009: You do your 2008 tax return. Since you have lost $1,000, you can reduce your ordinary income by $1,000, assuming you don't have any capital gains. If you are in the 25% bracket for example, you reduce your tax liability by $250. So, you invest the saving, $250, in Total Stock Market.

Suppose Total Stock Market keeps growing 8% year for 10 years after February, 2008.

January 2018: $10,000, which dropped to $9,000 in 2008, becomes $19,430.32 (= $9,000 * 1.08^10). $250 becomes $499.75 (= 250 * 1.08^9). Both of these combined, you have $19,930.07. You sell all shares and pay 15% tax on long-term capital gains. You end up with:

   $9,000+($19,430.32-$9,000)*85%+$250+($499.75-$250)*85% = $18,328.05

What if you didn't sell Total Stock Market in February, 2008? Note that you don't get $250 back in your 2008 tax return in 2009, so you end up with:

   $10,000+($19,430.32-$10,000)*85% = $18,015.77

Notice the $312.29 difference. This is what you get by investing $250 doing a tax loss harvesting. Obviously, the longer you hold shares you purchased with the $250 refund, the more benefit you get.

In this example, you got two types of benefits; you paid less in total tax, and the tax which you did owe was paid much later. When you deducted the $1,000 loss at a 25% rate, you created an additional $1,000 in capital gains to be taxed when you sold later (here, in 2018), but only at 15%. Essentially, the IRS paid you $100 of free money, and gave you an interest-free loan of another $150 in 2009 to be paid back only when you sold the stock. You benefited both from investing the $100 for its full value, and from the interest-free loan which allowed you to invest the $150 for ten years and pay back only the original $150.

In reality, things are a bit more complicated. In the above example, we completely ignored dividends from Total Stock Market. Also, the share price may change between February 2008 and March 2008.

Using a loss from one tax lot to offset the capital gains from another

Suppose the following:

January 2008: You invest $1,000,000 in Total Stock Market.

February 2008: You do tax loss harvesting after losing $100,000.

January 2010: You invest additional $50,000 in Total Stock Market.

January 2011: You retire. You sell the shares purchased in January 2010, which has grown to $60,000.

In 2011, you have not used up the loss realized in February 2008 as you can only deduct $3,000/year, so you can use a part of the remaining loss to offset the capital gain realized in January 2011.

If $60,000 is enough for your living expenses, you may have little or no taxable income because the gain is offset by the realized loss carryforward, and the return of capital, $50,000, is tax free. If this is the case, you might consider Post-Retirement Roth Conversion to take advantage of the standard/itemized deduction and low tax brackets.

Donating low basis shares to a charity

Suppose the following:

January 2008: You invest $10,000 in Total Stock Market.

February 2008: You do tax loss harvesting after losing $1,000.

March 2008: You reinvest $9,000 in Total Stock Market.

January 2009 and on: You make many purchases of shares of Total Stock Market.

January 2020: You donate the shares purchased in March 2008 to a charity.

If you donate the shares purchased in March 2008 to a charity, you do not have to pay tax on the capital gains. That is, you fully pocket the tax savings in 2008 and never "pay back" the savings to the IRS. See Donating appreciated securities for more details.

Stepped up cost basis upon death

Suppose the following:

January 2008: You invest $10,000 in Total Stock Market.

February 2008: You do tax loss harvesting after losing $1,000.

March 2008: You reinvest $9,000 in Total Stock Market.

January 2009 and on: You make many purchases of shares of Total Stock Market.

January 2020: You retire and start withdrawing from your taxable account, highest cost basis first.

Chances are you do not sell shares purchased in your life time, in which case, the shares purchased in March 2008 receive stepped up cost basis upon your death. That is, you fully pocket the tax savings in 2008 and never "pay back" the savings to the IRS.

What if the tax rates go up in the future?

Some people speculate that the tax rates may go up in the future. Tax loss harvesting still works as long as the increase is reasonable. Specifically, you benefit from tax loss harvesting as long as the tax you pay on the $1,000 extra capital gains ($10,000 - $9,000) in the first example above is less than the after-tax amount that $250 grows to. Suppose the long-term capital gain tax rate goes up to 30%. Then you would pay $300 on the $1,000 extra capital gains. However, $250 grows to $499.75 with the after-tax amount being $424.83, so you are not losing money yet.

Fine points about tax loss harvesting

Regulatory

  • Wash sale. If you sell Total Stock Market with losses and buy back the same fund within 30 days before or after the sale, that would be called a wash sale, and you cannot claim the losses on your tax return. The definition of a wash sale is a bit more complicated than that. Before you do tax loss harvesting, be sure to familiarize yourself with the wash sale rule.
  • Qualified dividends. If you hold shares less than 61 days and receive qualified dividends from those shares, they are not qualified dividends even though the fund company may claim to be qualified dividends. See Mutual Fund Ordinary Dividends for more details. Disqualification of qualified dividends may outweigh the benefit of tax loss harvesting in some cases.
  • Loss on mutual fund shares held 6 months or less. If you sell shares of a mutual fund at a loss, and those shares have been held for 6 months or less, then there are special rules that may alter the loss you claim. First, if those shares produced any tax-exempt interest, then the loss is reduced, dollar for dollar, by that interest. Second, if those shares were held while the fund distributed (long term) capital gains, then the loss is treated as a long term loss up to the dollar amount of the distribution those shares produced.[1][2] Vanguard, and likely most other brokerages, will not make the correct adjustment on your IRS Form 1099-B, so you will have to correct it yourself by filing Form 8949 and changing the type of capital loss.[3]
Note that most Vanguard Tax Exempt funds (and others like them) are not subject to the preceding 6 month rule because of the way they accrue and pay out interest (dividends). The 6 month rule for tax exempt interest comes from 26 U.S. Code § 852(b)(4)(B), but there is an exception in 852(b)(4)(E) for funds that declare dividends daily and pay them monthly or more frequently.[4] [5]
However, ETFs and the Tax-Exempt Bond Index Fund (which is the mutual fund class of an ETF) are subject to the six-month rule, because they declare dividends monthly, not daily. 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.
  • Death of taxpayer. Capital losses cannot be carried over after a taxpayer's death. They are deductible only on the final income tax return filed on the decedent's behalf. (IRS pub 544).

Operational

  • Reinvestment of dividends and capital gains. If you automatically reinvest dividends and capital gains, you may accidentally trigger a wash sale. If you plan to do tax loss harvesting, it's generally safer to take dividends and capital gain distributions in cash.
  • Cost basis accounting. Use Specific identification of shares instead of average cost basis to sell shares with losses.
  • Put volatile investments in your taxable account. For example, an international fund has larger ups and downs because of political and currency risks. This makes it more likely for you to be able to do tax loss harvesting.
  • Commissions and bid/ask spreads. If you are doing tax loss harvesting on ETFs and/or individual stocks, you may have to pay commissions and bid/ask spreads, and they reduce the amount of money you get from tax loss harvesting. For this reason, you may want to compare the amount of tax you save and the trading costs and do tax loss harvesting only when the trading costs are minimal compared to the savings in the current tax liability.
  • Mutual funds. You don't have a problem with commissions or bid-ask spreads. However, some mutual funds have redemptions fees for a certain period after the purchase. Another problem is that you could try to realize a small loss in a mutual fund position, but the loss may disappear by the time the redemption is processed. For this reason, you may want to do tax loss harvesting on a sizable loss that's unlikely to disappear in one day.
  • Frequent-trading restrictions. Vanguard does not allow you to sell most funds and buy back into the same fund electronically within 30 days.[note 2] If you plan to buy the fund back in 31 days, one of the two transactions must be done by mail.
  • Volatility of investment. In the real world, a tax loss harvester waiting 31 days to reinvest will see volatility in the investment. If the price of the investment goes up while the investor is on the sidelines she is disadvantaged; if the price goes down, she is advantaged. One might expect that over a long period of tax harvesting these volatility effects might wash out (if random) or perhaps, if there is a short term momentum effect, a slight advantage to the loss harvester over the long haul. This volatility of reinvestment risk can be mitigated if one immediately purchases a similar, but not substantially identical investment, but this comes with a higher degree of complexity especially if one is swapping fractional lots of the original fund.

Should I TLH before or after a distribution?

The general rule is to sell before and buy after a dividend and capital gains distribution. The more important concern is to buy after the distribution; if you sell Fund A to buy Fund B, you want to wait until after Fund B makes a large distribution, even if you receive a distribution from Fund A. The reason is that you pay tax on any distribution, but every dollar of distribution reduces the fund's NAV by one dollar, so you get a tax benefit from this dollar as a capital loss (or reduced gain) if you sell. When you are selling Fund A to TLH, you will always get the capital loss. If you buy Fund B, you do not get any benefit from the capital loss until you sell. Even if you intend to switch back immediately, if Fund B pays a qualified dividend, you need to hold Fund B for 61 days rather than 31 or else the dividend loses its qualified status, and waiting 61 days increases the potential cost of switching back.

It is usually desirable to TLH before a distribution as long as you need not buy the replacement fund before its distribution, but it depends on the type of distribution. If the distribution is a capital-gains distribution, then it is exactly canceled by the capital loss, so there is no net tax effect. If the distribution is an ordinary dividend then it has increased taxes at the marginal tax rate, and the capital loss is likely to give less in tax savings. If the distribution is a qualified dividend and the capital loss offsets long-term gains, this is break-even because the qualified dividend and reduced capital gain are taxed at the same rate. If the distribution is a qualified dividend and the capital loss offsets short-term gains or ordinary income, there is a benefit for waiting. And if the distribution is a mostly qualified dividend with foreign tax credit, you may pay tax at less than the long-term gains rate, and should wait for the distribution before harvesting the loss.

When not to harvest losses

When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both. If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss. Here is why:

A tax loss harvest can be thought of as a loan from the IRS in the following sense. If the funds generated by the sale are reinvested in the same or similar securities (after waiting 31 days if necessary to avoid a wash sale), then the transactions have resulted in a lower basis. Ultimately, if the asset price of that security increases you will pay taxes on capital gains when you sell. Thus, the TLH tax benefit ultimately may result in a higher capital gains taxes in a future year than you might have otherwise incurred. So, if the TLH offsets capital gains that would have been taxed at 0% but your future capital gains rate is not 0% then the TLH induces a loss. Fundamentally, there is no benefit to offsetting capital gains that are not taxed anyway.

Bottom line: know your tax rates before you TLH.

What if the stock is worthless?

If a company fails, the IRS imposes different rules.[6]

Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became completely worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long term or short term.

Report worthless securities in Form 8949, Part I or Part II, whichever applies. You may need to file an amended return to report a stock which became worthless in a prior year.[7]

Substitute funds

Below is a list of possible substitute ETFs for a given asset class which track similar, but not identical indices.

Asset Class Vanguard ETF Vanguard Benchmark Substitute ETF Substitute Benchmark
US Stocks VTI CRSP US Total Market ITOT S&P Total Market
SCHB DJ Broad US Market
Foreign Stocks VXUS FTSE Global All Cap ex US IXUS MSCI ACWI ex USA IMI
Foreign Developed Markets VEA FTSE Developed Markets Ex-North America IEFA MSCI EAFE IMI
SCHF FTSE Developed Markets Ex-US
Emerging Markets VWO FTSE Emerging Markets EEM MSCI Emerging Markets Index
IEMG MSCI Emerging Markets Investable Market Index
Dividend Stocks VIG NASDAQ US Dividend Achievers Select SCHD Dow Jones U.S. Dividend 100
TIPS VTIP Barclays Capital US TIPS 0-5 Years SCHP Barclays Capital US TIPS

Notes

  1. Tax loss carryover to the following year is mandatory. See this Bogleheads forum topic: "If you TLH, do you have to apply it that tax year?", geospatial. June 22, 2020.
  2. There are some exceptions. See: Vanguard Exchange policy

See also

References

  1. Publication 550 (2014), Investment Income and Expenses, "Loss on mutual fund or REIT stock held 6 months or less," Viewed September 02, 2015
  2. Corrections for the wiki article on TLH, forum discussion.
  3. TLH holding period not met for LTCG distributions; how to report?, forum discussion.
  4. Re: Yield on Vanguard Int. Term Tax Exempt Fund, forum discussion.
  5. 26 U.S. Code §852 law.cornell.edu.
  6. Publication 550 (2015), Investment Income and Expenses, direct link to section (Worthless securities). Accessed January 27, 2017.
  7. Re: How to Recognize Capital Loss, forum discussion, direct link to post.

External links