Tax Loss Harvesting at Vanguard A Primer

Transcription

1 Tax Loss Harvesting at Vanguard A Primer In June of this year, there was a period of time where stocks dropped for about 6 days straight. In fact, if you look carefully at the chart, there were similar episodes, at least for international stocks, in February, March, and May as well. If you had purchased an international stock index fund at any point during 2018, chances were very good by June 19th that you had a loss you could tax loss harvest, especially if you had not already done it this year. (Obviously the really astute probably already did this in February, March, or May.) So I sent a Tweet out to my Twitter followers: and linked to a blog post I had on Tax Loss Harvesting (TLHing), at which point I realized I had not written on this subject since So I thought I d document my process on how to tax loss harvest with Vanguard. How Tax Loss Harvesting Knocked $2,367 Off My 2018 Tax Bill in 30 Seconds That was my alternative click-baity title for this post. It s completely true though. Let me demonstrate. First, I went to Vanguard and logged in. I clicked on My Accounts and then Account Overview and then our taxable Brokerage account. Finally, I clicked on Cost Basis and this is what I saw: This is the money shot where you determine whether you have

2 any losses to harvest. You can see the funds, ETFs, or individual securities on the left by ticker symbol, then the name of the fund, the number of shares you own, the total cost, the market value, the short-term gain or loss, the longterm gain or loss, and the total gain or loss in the column on the right. That s the one to look at. If anything in that column is red, then you ve got some work to do. As you can see in my case, our VTIAX holding (Total International Stock Market Fund) has a $5, loss at the beginning of the day. Share Identification Vanguard (and most brokerages) offer three cost basis methods: First In, First Out Average Cost Basis Specific Identification As a general rule, the best one is Specific Identification and the worst one is First In, First Out. That s because when you go to tax loss harvest, you usually want to sell the LAST shares you bought, not the first ones, because the last ones generally have the biggest loss to harvest. If you look at the details under the Total Stock Market Index Fund, you can see that I bought various shares on various dates. This is the benefit of using Specific Identification. With one click on Show details I can see that I don t have a single lot of VTSAX that has a loss. Despite that Specific ID is the best, the default setting at Vanguard is Average Cost Basis, which you should change to Specific Identification. Of course, it takes a day to make that change, and I didn t want to wait in case the market had a huge rebound the next day. The default during that day while the change is being made is, strangely enough, First In, First

3 out! I know, crazy right? At any rate, it turned out for me it didn t matter, because ALL of the lots of VTIAX that I owned were purchased at a higher price than what it was now trading at. Since I hadn t picked Specific Identification a priori, I had to look that up manually under the transaction history page. If I limit the parameters to VTIAX and Buy, I can see that I purchased it at $30.47, $30.75, $30.77, and $ Since it traded yesterday at the close at $29.91, it doesn t matter whether I use FIFO, Average Cost Basis, or Specific ID, it s all the same! Also, since the market was open, I quickly went and looked up the ETF counterpart of this fund to make sure my loss wasn t being erased due to market action today. This is what I found: Looks like it was down another 1.29%, so it was a pretty safe bet that not only would my loss NOT be erased, but that there would be some additional loss there to harvest by 4 pm EST when the tax loss harvesting transaction takes place. So let s put in the order. Making the Transaction Okay, now the first thing you do is hit Exch for exchange on the right side of the screen for the fund I want to exchange, because I m going to exchange one fund for another. That takes you to this screen: It all was bought at a price higher than what it can be sold for today, so I chose to sell 100% of it. As noted above, I

4 was stuck with the FIFO method on the day I made the exchange, which was fine in my case. Next, I needed to choose a fund to exchange into. Remember the goal with tax-loss harvesting is to choose something that is highly correlated with the original fund, while not, in the words of the IRS, substantially identical. At Vanguard, the usual first choice for the Total International Stock Market Index Fund is the FTSE All-World ex-us Index Fund. Since I had more than $3K, I was using the Admiral shares instead of the higher-priced Investor shares. Why is that fund such a great TLHing partner? Well, take a look at this: As you can see, the performance is nearly identical both year to date and over the last 5 years. The expenses are identical and they both invest in large international blend stocks. So clearly, the funds have very high correlation. I should expect nearly identical performance out of them. But are they substantially identical in the eyes of the IRS? I would argue that they are not. For example, VTIAX holds 6,330 stocks, has $343 Billion invested in it, and is managed by Michael Perre and Christine Franquin. VFWAX holds 2712 stocks, has $32 Billion invested in it, and is managed by Christine Franquin and Justin Hales. I think I ve got a very good argument for the IRS that they are NOT identical given that one holds 4000 stocks that the other does not. At any rate, I ve NEVER heard of anyone having to actually make this argument. The IRS simply doesn t care as long as you re buying a different fund. So VFWAX it is. I choose it on the next page. Then I agree to get my fund prospectus electronically (like I m going to read that for a fund I ve held off and on for years.)

5 Next is the submission page followed by the nearly identical confirmation page. Voila! I have tax loss harvested. Note that Vanguard won t let me buy any more shares of VTIAX for a month in this account, which is fine since I don t want to buy any for a month in any account anyway because it would cause a wash-sale and void my tax loss. Adding Up the Benefit So how much did I save in that 30 seconds? Let s add it up. First, let s see what the shares actually sold at. If I go back at the end of the day or the next day, go to cost basis in that account, and look at realized gains/losses I see that my actual loss was $7, When tax loss harvesting, up to $3,000 can be applied against your ordinary income, which in my case is taxed at 37% Federal + 5% state, or 42%. So a $3,000 deduction is worth $3,000 * 42% = $1,260 off my tax bill. The remaining loss is carried forward to the next year. Of course, the $3,000 loss is only good if there is $3,000 left AFTER it is applied against all of your short and long-term capital gains on Schedule D.

6 Now for most of us, our tax software (or that of our tax preparer) takes care of all of those complicated looking worksheets for us. But the bottom line is that ONLY the amount of your loss above and beyond your short-term capital gains and long-term capital gains can be applied to your ordinary income and only up to $3,000 per year with the remainder being carried forward to future years. So in my case, I won t really know exactly how much money I saved by tax loss harvesting until I find out what my capital gains for the year are. But even if I had more than $7, in long-term capital gains distributed from my mutual funds, at a minimum I would save the taxes on those, currently at 23.6% for us. $7, x 23.6% = $1,815. Perhaps more likely, $3,000 of it goes against my regular income ($1,260 off my tax bill) and $4,690 goes against some LTCG distributions ($1,107) for a total of $2,367 off my tax bill. Certainly worth 30 seconds of my time. But You re Only Deferring the Taxes! Now, the semi-knowledgeable critic might point out that TLHing really only defers paying taxes, it doesn t actually lower them. So let s make that critic more knowledgeable and less critical and point out why TLHing is still a good idea, particularly for me. There are three aspects to consider. Platinum Level Scholarship Sponsor First, it is true that if I eventually sell these funds, that I now have a lower basis in them, and thus a larger percentage of what I sell them for will be gain and have taxes due. However, money now is worth more than money later. This is

7 what we call the Time Value of Money. If you assign 4% per year to its value, and you defer paying those taxes for 10 years, well, 1.04^10 1 = a 48% gain on that money. So if you saved $1,260 in taxes now and paid $1,260 in taxes later, your actual savings is $605. Sure, that s less than $1,260, but it sure beats a kick in the teeth. Second, there is a bit of an arbitrage between tax rates. If you can come up with a $3,000 deduction against your ordinary income tax rate (let s use 42%) now and then later have to pay taxes on that $3,000 at your long-term capital gains rate (let s use 23.8%), you re saving $1,260 and paying $714, a tax savings of $546. Add that to the $605 from the time value of money over a decade, and you re back up to $1,151, awfully close to the $1,260 you knocked off your initial tax bill. Finally, the critic is not only semi-knowledgeable about the tax code, but he s semi-knowledgeable about my personal tax situation. You see, there is a very good chance I will never sell these shares. They will probably either be donated to charity (in which case I not only get the itemized tax deduction on Schedule A, but neither I nor the charity pay any long-term capital gains whatsoever) or left to my heirs (where they receive a step-up in basis at death and thus no income taxes due.) So the tax savings is very much real to me. Tax loss harvesting and then flushing the additional gains out of your portfolio through charity (and death) is a very taxefficient way to invest. Bonus Material: Another Opportunity to Harvest A few days after I did all this tax-loss harvesting (and wrote this post), I had the opportunity to do it again and score another $7,800 in tax losses. I thought there might be a worthwhile lesson in telling you about those transactions too. Both international stocks and US stocks were down for the day

8 and I had some big red negative numbers when I checked my basis. So I sold a couple of lots of my Total Stock Market Index Funds (only two had a loss, the rest still had a gain.) I exchanged into the Vanguard Large Cap Index Fund (a bit more like TSM than 500 Index is.) I also sold the FTSE Ex-US Fund that I had just purchased. What did I exchange that into? 20% into the Vanguard Emerging Markets Stock Index Fund and 80% into the Vanguard Developed Markets Index Fund. Check it out: So now, after doing all that, under the cost basis tab I can see my realized losses for the year. Now I ve got over $15K in losses to use on my 2018 tax return, which I can really use given that we re taking the standard deduction this year after bunching many of our itemized deductions last December. For now, I m done with tax-loss harvesting. How do I know I m done? Because when I look at all my tax lots on the unrealized gains/losses tab I see nothing but green: The Bottom Line Okay, so what have we learned about tax loss harvesting today? Let s list it out: # 1 You should do it if you are given the chance. It will save you money. # 2 Beware the wash-sale rules. You can t buy back what you just sold in any investing account (including your spouse s) for 30 days. No, you can t buy more shares just before you sell them either. That 30 days goes both forward and backward.

9 This nine year old might not be able to grow a real beard, but he could definitely figure out tax loss harvesting. # 3 Don t sweat the substantially identical rules. As long as you re buying a different fund (not a different share class of the same fund) the IRS isn t going to hassle you about it. So buy a fund that is very highly correlated to the original one. Some good examples of TLHing partners for commonly owned Vanguard funds include: Total Stock Market Index Large Cap Index, 500 Index, Fidelity TSM, Schwab TSM Total International Stock Market Index FTSE All World Ex-US Index, Developed Markets Index, Fidelity TISM, Schwab TISM, a combination of Developed Markets and Emerging Markets Index Funds REIT Index Fidelity Real Estate Index Fund, Schwab REIT ETF Small Cap Value Index Small Cap 600 Value Index, Russell 2000 Value Index Hard-core investing aficionados can argue all day about the merits of one partner over another, but the point is to get something reasonably similar whenever you can. Sometimes you do need two or three of them for a single asset class if the market is dropping rapidly, but you always have the option to just wait 30 days before repurchasing what you sold. Of course, there is risk there that the market rebounds rapidly and you end up selling low and buying high, so I prefer to exchange to another fund rather than wait. What do you think? Have you tax-loss harvested before? Why or why not? What did you find difficult about it? What

10 recommendations do you have for someone who has never done it before? Comment below!