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Tax Loss Harvesting Questions
Old 03-23-2014, 09:11 PM   #1
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Tax Loss Harvesting Questions

I realize this is not the usual time of year for tax loss harvesting questions, but what the heck.. There are a lot of smart and knowledgeable people here so I am trying to take advantage.

I understand that the general idea behind tax loss harvesting is to sell investments that have losses and use those losses to offset income, thereby reducing one's current-year income tax. To me, this never seemed all that important, because I would not want to change my asset allocation - so if I sold something at a loss, I would want to buy it back ASAP. Meaning either waiting for the 30-day wash sale period or buying something similar but not identical (Question 1: Would it avoid wash sale rules to sell a total market index fund for a tax loss and immediately buy a S&P 500 fund? They are different, but very highly correlated.). This means that I would just have a lower basis in the investment and have to pay more tax sometime in the future when I sell.

But perhaps there is an advantage here. If your current marginal tax bracket is 28% or 33%, for example, you might be saving money at that rate by tax loss harvesting. Then, sometime in the future, you might be retired and selling your asset, being taxed at long-term capital gains rates. So even though you lowered your basis and will now have to pay tax, you would pay the tax at a rate of 15% (or maybe even 0%?). Question 2: This idea is predicated on whether it is legal to offset current earned income taxed at marginal rates with long-or-short-term capital losses; is this possible? I seem to recall that this is possible but that there is a low limit for how much can be offest - but then that there is some ability to carryover losses to later years?

Question 3: Is this, then, the goal of tax loss harvesting - to save money that would be taxed at the higher tax rate today with the expectation of paying the tax at a lower rate in the future?
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Old 03-24-2014, 12:32 AM   #2
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Originally Posted by progmtl View Post
(Question 1: Would it avoid wash sale rules to sell a total market index fund for a tax loss and immediately buy a S&P 500 fund? They are different, but very highly correlated.). Question 2: This idea is predicated on whether it is legal to offset current earned income taxed at marginal rates with long-or-short-term capital losses; is this possible? I seem to recall that this is possible but that there is a low limit for how much can be offest - but then that there is some ability to carryover losses to later years?

Question 3: Is this, then, the goal of tax loss harvesting - to save money that would be taxed at the higher tax rate today with the expectation of paying the tax at a lower rate in the future?
1) IRS rule: A wash sale occurs when you sell or otherwise dispose of stock or securities (including a contract or option to acquire or sell stock or securities) at a loss and, within 30 days before or after the sale or disposition, you: Buy substantially identical stock or securities,

I suppose folks could have different opinions but I personally would have a problem claiming TSM is substantially identical to S&P500 even tho they are highly correlated............so I would think this is ok.

2) TLH losses are applied first against other capital gains, then against ordinary income......for the latter only 3K of losses can be applied each yr.
The rest is carried over to future yrs.

3) The goals of TLH are to take a loss now and lower your tax on ordinary
income now and succeding years, even if you end up paying more CG taxes
in the future due to the lowered basis. Ex: you buy stock for 30K and sell
for 0 for a TLH of 30K. You rebuy at 0. You take 3K loss against ordinary income for 10yrs and the next year you sell the stock for 30K. In the first 10 yrs, you have taken a 30K loss against ordinary income. If in the 25% bracket, you have recovered 7.5K. When you sell the stock , you have a CG of 30K. Even if you paid CG taxes at 25% for 7.5K, you would end up ahead because presumably you had invested the 7.5K you recovered earlier
(time value of money). The fact that CG tax rates are lower than ordinary income rates is a bonus but a significant one here so you gain on both fronts.

Having the tax loss carryover is nice if you have funds that throw off CG distributions that vary from year to year since the carryover can buffer your final income and make it more predictable.
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Old 03-24-2014, 04:14 AM   #3
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To further amplify Kaneohe fine post. The time value of money when coupled with the magic of compounding make this a very important strategy to employ.

Say you had purchase 40K worth of Vanguard Emerging market ETF VWO in Jan and 11+ months later it had dropped 25% and is now worth 30K. You are in the 25% tax bracket and have more than $10,000 of short term CG. You sell the Vanguard Emerging market index ETF VWO and you get a $2500 in tax saving. You then immediately reinvest the $30,000 plus your $2,500 in tax saving into the Schwab Emerging Market Index ETF SCHE. Over the next ten years the fund averages 10% per year your fund is now worth $84,300 your basis for the fund is $32,500 and you will owe $7,770 in tax on the LT Cap gains leaving you with $76,530 after taxes.

Option 2 is do nothing. Over the next ten years VWO also returns 10% per year making the $30,000 worth $77,810 in ten years time. Your basis is higher (40K) so you owe less taxes $5,670 but after taxes you are left with $72,140.

So as you can see you end up almost $4,400 by simply biting the bullet and taking your losses at the end of the year. You aren't really changing your AA other than adding a bit more to your Emerging Market allocation.
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Old 03-24-2014, 04:19 AM   #4
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Answers to your questions:
1. Yes.
2. Yes and yes.
3. Yes.
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Old 03-24-2014, 08:14 AM   #5
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Answers to your questions:
1. Yes.
2. Yes and yes.
3. Yes.
+1 Total Stock and the S&P 500 would not be similar.
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Old 03-24-2014, 08:37 AM   #6
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This is great information, thanks to all who replied. A couple of followup questions:

Question 4: One example was given which involved selling an emerging markets ETF and immediately buying a different company's emerging markets ETF. Would this avoid the wash sale restriction? I'm thinking if both ETFs track the same index then they are "substantially identical". I suppose they might be considered different if they have different investment approaches.

Question 5: Most of my taxable investments are in Vanguard total stock market index fund and Vanguard tax-managed international stock index fund. Both of these are sitting on large gains from recent years. I have currently elected to use the "average cost" method for calculating the basis. This would seem to indicate that if the market makes a downturn and I still have an overall gain I could not employ tax loss harvesting. Would I need to switch to some other method for basis calculation whereby I select the exact shares to sell in order to sell shares at a loss? And would this make tax accounting a nightmare going forward, as I regularly contribute to these funds?
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Old 03-24-2014, 08:52 AM   #7
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On Q4, it would be a closer call than your Total Stock>S&P500 example, and you would have to look at the underlying investments and returns to assess how similar they are. But for example, if one is an index fund and the other is a managed fund, then they would probably be dissimilar enough.

On Q5, you can switch to specific identification to better manage your tax situation and the fund companies will take care of the tracking for you.
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Old 03-24-2014, 09:06 AM   #8
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A5: In the old days, if one had already sold shares and used average basis, then one could not switch between average basis with its first-in/first-out identification of shares sold and specific identification of shares sold. With the new rules and 1099B's where one's broker reports the cost basis of the shares you sold, it is not clear to me that one can switch methods if they have already used another method on their tax return. This is open to debate.

A4: I have used EEM and VWO as tax-loss harvesting pairs, but I don't think at the time they tracked the same index and certainly their top-10 holdings were different. This is open to debate with opinions all over the map on this. Nevertheless, it is so easy to avoid this similarity, so the question really shouldn't come up anymore.
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