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Old 04-19-2009, 11:29 AM   #41
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Yes, in tax-deferred, there's no point to a basis (from a tax standpoint) and it don't matter what you do. The question is about taxable accounts.

Thanks, though.
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Old 04-20-2009, 09:59 AM   #42
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Audrey,

I'm curious about your strategy for rebalancing in taxable at that point. I'd assume that you would have some shares underwater, some about even, and some up, plus potentially some substantial paper losses due to tax-loss-harvesting. So what would you sell, in what order, and with what rationale?

(Others should feel free to chip in too.)

Thank you.
Rebalancing (in a non tax-deferred account) is a taxable event. Can't really do anything about it. If I'm trimming winning equity funds, I'm realizing gains so there is a tax cost - but at least it's at capital gains tax rates. If equities are down and I'm selling bond funds to buy equities that is often a tax loss event because I each time I pay taxes on bond fund distributions the fund basis is raised.

I don't choose anything according to its basis - each fund is trimmed or added to by how much it is above or below its target allocation.

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Old 04-20-2009, 10:07 AM   #43
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Oh, wait - there"s more......!

An important little refinement that attempts to minimize the taxable events due to rebalancing:

One trick I employ is to not reinvest distributions in mutual funds that are have moved above of their target allocation during the year since I have to pay taxes on these distributions anyway. This takes care of some of the "trimming".

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Old 04-20-2009, 12:27 PM   #44
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If equities are down and I'm selling bond funds to buy equities that is often a tax loss event because I each time I pay taxes on bond fund distributions the fund basis is raised.
Thanks Audrey,

Please pardon what may be elementary questions.

First, can you explain the above point further? How do bond fund distributions (by this you mean dividends or sales of shares?) increase the basis?

Then, suppose that through market turmoil, some (stock) shares are up, and some down, yet you are intent on selling some shares. Which shares go, and in what order, assuming you use the specific shares method of reporting?

Then, suppose you also have a realized loss through tax loss harvesting, well in excess of what you expect to use via a yearly 3k deduction. How might this affect your decision?

Thank you again.
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Old 04-20-2009, 12:49 PM   #45
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Distributions (mutual fund distributions include dividends or any short and long-term capital gains realized ) paid from a mutual fund increase the basis because you pay tax on the distributions. That's how taxes on mutual funds work. Then when you sell mutual fund shares later, any distributions paid out already increase the basis because you already paid tax, you only pay tax on any additional gains.

On picking which shares of a stock to sell during rebalancing — well, I only own mutual funds and I use the average cost basis, so I don't get to pick a specific lot to sell. Fidelity tracks this average basis for me (and the calculation takes into account the raised basis due to all distributions paid). Of course if you DO get to select a specific lot then choosing the lot with highest basis first held for at least 12 months would be prudent. Easy enough to do with stocks, but IMO too complicated for me with mutual funds.

If you have realized a loss via tax loss harvesting, this can be applied against any (taxable) capital gains distributions paid out by mutual funds that same year. Only once you've exceeded those are you then limited to $3K against ordinary income.

Audrey
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Old 04-20-2009, 02:39 PM   #46
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Thanks Audrey,

Ah, yes, now I dimly remember that basis issue (hasn't come up for me yet).

I've been using the specific shares method, with manual book-keeping. I don't automatically reinvest dividends, etc., to keep that more manageable. Instead, I've used that money to make less frequent purchases for rebalancing, etc.

The general advice is to sell the highest-basis shares first, as that normally results in the least tax bite. However, if you have a mix of shares, some that are up and some down, selling the highest basis shares results in being taxed, which is avoidable.

Alternatives include (a) selling what shares you have whose basis is (approximately) fairly valued, for no substantial net gain or loss, or (b) selling a mix of the highest basis and lowest basis stock such that there is no net gain or loss. I think these two are completely equivalent, but I should do some math to verify this.

Another option is (c) to take the gain (sell lowest basis) and run, to the degree that old excess tax-harvested losses are available. However, this is effectively paying back the "tax-free loan" aspect of tax-loss harvesting, which one would normally like to stretch out.

Finally, one could sell the highest basis shares for a loss. However, this wouldn't seem to make much sense except for further tax-loss harvesting.

So, I think (a) and (b) are equivalent and probably is the best strategy in the absence of some reason why taking gains against old losses (c) is preferable. Perhaps changes in tax rates and rules might trigger the latter.

(Edited) Now I think that perhaps a more optimum strategy is to sell the fewest number of shares possible, however they are allocated, consistent with any other goals such as avoiding paying capital gains taxes. This maximizes future dividend payments. However, this may also be equivalent with (a) and (b).

Any comments from anyone, or links to discussions of this sort of optimization?

Thanks.
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Old 04-20-2009, 09:28 PM   #47
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The following is excerpt from IRS Publication 564, regarding various methods to determine the cost basis. As it is usually of a tax advantage for the investor to sell the most recently acquired shares first, in contrast to the early shares which tend to have a lower basis, the IRS has provided more hurdle to the share seller. He would have to designate the shares identified by date of purchase to his broker, who then has to provide confirmation in writing.

I know of no online brokers who have software to let you make such designation to sell. And if the shares have been transferred from one brokerage to another, the purchase history is lost, and is only known by the investor who hopefully has kept a paper record. He still has no way of telling his new broker to sell XX shares purchased on a certain date with the previous broker.

Because of this hassle, I use the FIFO method, which is of course not tax-efficient. However, I have more stocks than mutual funds, and usually do tax loss selling on the stocks in the taxable accounts. If I need to sell mutual funds for AA rebalancing, I usually sell MFs in the tax-deferred accounts to avoid the basis computation hassle.

Cost Basis

You can figure your gain or loss using a cost basis only if you did not previously use an average basis for a sale, exchange, or redemption of other shares in the same mutual fund.

To figure cost basis, you can choose one of the following methods.
Specific share identification.

First-in first-out (FIFO).
Specific share identification. If you adequately identify the shares you sold, you can use the adjusted basis of those particular shares to figure your gain or loss.
You will adequately identify your mutual fund shares, even if you bought the shares in different lots at various prices and times, if you:
Specify to your broker or other agent the particular shares to be sold or transferred at the time of the sale or transfer, and
Receive confirmation in writing from your broker or other agent within a reasonable time of your specification of the particular shares sold or transferred.
You continue to have the burden of proving your basis in the specified shares at the time of sale or transfer.

First-in first-out (FIFO). If your shares were acquired at different times or at different prices and you cannot identify which shares you sold, use the basis of the shares you acquired first as the basis of the shares sold. In other words, the oldest shares you own are considered sold first. You should keep a separate record of each purchase and any dispositions of the shares until all shares purchased at the same time have been disposed of completely.
Table 3 (on the next page) illustrates the use of the FIFO method to figure the cost basis of shares sold, compared with the use of the single-category method to figure average basis (discussed next).

Average Basis

You can figure your gain or loss using an average basis only if you acquired the shares at various times and prices, and you left the shares on deposit in an account handled by a custodian or agent who acquires or redeems those shares.

To figure average basis, you can use one of the following methods.
Single-category method.

Double-category method.
Once you elect to use an average basis, you must continue to use it for all accounts in the same fund. (You must also continue to use the same method.) However, you may use the cost basis (or a different method of figuring the average basis) for shares in other funds, even those within the same family of funds.


Single-category method. Under the single-category method, you find the average basis of all shares owned at the time of each disposition, regardless of how long you owned them. Include shares acquired with reinvested dividends or capital gain distributions.
Table 3 illustrates the use of the single-category method to figure the average basis of shares sold, compared with the use of the FIFO method to figure cost basis (discussed earlier).
Even though you include all unsold shares of a fund in a single category to compute average basis, you may have both short-term and long-term gains or losses when you sell these shares. To determine your holding period, the shares disposed of are considered to be those acquired first.

Double-category method. In the double-category method, all shares in an account at the time of each disposition are divided into two categories: short term and long term. Shares held 1 year or less are short term. Shares held longer than 1 year are long term.
The basis of each share in a category is the average basis for that category. This is the total remaining basis of all shares in that category at the time of disposition divided by the total shares in the category at that time. To use this method, you specify, to the custodian or agent handling your account, from which category the shares are to be sold or transferred. The custodian or agent must confirm in writing your specification. If you do not specify or receive confirmation, you must first charge the shares sold against the long-term category and then charge any remaining shares sold against the short-term category.

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Old 04-20-2009, 10:08 PM   #48
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The general advice is to sell the highest-basis shares first, as that normally results in the least tax bite. However, if you have a mix of shares, some that are up and some down, selling the highest basis shares results in being taxed, which is avoidable.
?? The shares with the "highest basis" are the shares that you paid the most for. Since you pay tax on the difference between the price you paid when you bought them and the price when you sold them, these shares would generate the lowest tax bite.

Part of any optimization strategy will involve guessing the the expected future tax rate you will have to pay. If (as is presently scheduled to happen) the Cap gains rate goes up to match the earned income rate, you might have been better off to pay the cap gains now rather than the higher rate later.

I'm no expert. I use the average cost basis and keep things simple, though I know it costs more money in taxes.
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Old 04-21-2009, 12:57 AM   #49
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With the huge caveat if will past IRS muster or not... Here is what I do.

Years ago I sent a letter to Schwab instructing them to sell the stock with the highest cost basis for gains, and the lowest cost basis for losses.

Over the last 5 or 6 years it has actually gotten easier to implement. In the performance section of the website, there is a way of entering cost basis (generally it is filled in automatically) for shares. Then when you sell the shares Schwab ask you to identify which shares you sold so I fill that section out.

Now, this method doesn't live up to the letter of the IRS regulation, but since I do identify the specific shares I am selling shortly after the sales (and generally before the trade clears), I think I am living up to the spirit. There is also an electronic audit trail. If the IRS wants to come after me so be it, but I've been doing this for well over a decade with no problems.
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Old 04-21-2009, 02:13 AM   #50
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NW-Bound:

Vanguard will manually send you the "adequate" documentation identifying specific shares if you call them up (or at least they will if you are a higher-tier customer). Once you take care of getting the documentation, you go ahead and sell on your own the normal way. It's a huge pain compared to merely clicking a few buttons, though.

Samclem:

Correct - I mis-wrote. I need to hurry up and retire before my last few functioning neurons go.

I remember earlier discussions (pre-crash) about the expected rise in capital-gains taxes, and people doing break-even analysis. Post-crash, it seems that many fewer people need worry about capital gains. But who knows, maybe there will be a mad dash to a full recovery just in time.

Clifp:

I'm with you on the "sprit" of the rules.

Vanguard should get up to speed and track specific shares in mutual funds. Meanwhile, the IRS is obviously still stuck in an earlier age given their expectation that a "broker" is involved.

By the way, there are those who say that one can informally switch from FIFO to Specific Shares, as they are compatible methods (the specific shares are just the earliest) provided that one never specifies FIFO (FIFO is the default, though) and finally does specify Specific Shares once that method is employed. I'm not sure I'd care to try that, though, as the IRS could conceivably claim that you have switched methods without permission.

Thanks.
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Old 04-21-2009, 03:46 AM   #51
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Personally, my fear of the IRS has decreased dramatically after the latest scandal about administration officials

Here is a snippet from the WSJ article on Geithner.

Quote:
In 2006, the IRS audited Mr. Geithner's 2003 and 2004 taxes and concluded he owed taxes and interest totaling $17,230, according to documents released by the Senate Finance Committee. The IRS waived the related penalties.
During the vetting of Mr. Geithner late last year, the Obama transition team discovered the nominee had failed to pay the same taxes for 2001 and 2002. "Upon learning of this error on Nov. 21, 2008, Mr. Geithner immediately submitted payment for tax that would have been due in those years, plus interest," a transition aide said. The sum totaled $25,970.
The Obama team said Mr. Geithner's taxes have been paid in full, and that he didn't intend to avoid payment, but made a mistake common for employees of international institutions. That characterization was contested by Senate Finance Republicans, who produced IMF documents showing that employees are repeatedly told they are responsible for paying their payroll taxes.
As to why Mr. Geithner didn't pay all his back taxes after the 2006 audit, an Obama aide said the nominee was advised by his accountant he had no further liability. Senate Finance aides said they were concerned either Mr. Geithner or his accountant used the IRS's statute of limitations to avoid further back-tax payments at the time of the audit.
Other tax issues also surfaced during the vetting, including the fact Mr. Geithner used his child's time at overnight camps in 2001, 2004 and 2005 to calculate dependent-care tax deductions. Sleepaway camps don't qualify.
Now this isn't a political statement, but just my observation, that unless you are deliberately attempting to defraud the government the IRS doesn't seem to be particularly nasty recently.
Two things stand out. First they IRS waived penalties. Second despite clear evidence that Geithner screwed up the IrS wasn't smart enough and audit previous year returns. So even if the IRS audits you one time and rules against your method, it seems unlikely that you'll owe more than interest on the taxes.

Finally what are these capital gains you are writing.
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Old 04-21-2009, 08:30 AM   #52
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I just now saw Ha's post here.

My portfolio has performed about the same as Ha's and I have wondered what to do, too. Since I couldn't come up with any better ideas, I am sticking with my basic plan: 70/30 equity/bond funds & CDs, and the equity 50/50 US/foreign. Starting in the middle of last year, I began to build a CD ladder.

It would be real nice for my valuations to go back up. Theory says they will. I am guessing that this will take a few years, though. Time for strong stomachs.

I wonder how gummy is doing these days? There is a quant's quant! Does he ever get the willies in times like these, or is he a man of iron? Inquiring minds want to know!

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Old 04-21-2009, 08:32 AM   #53
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Distributions (mutual fund distributions include dividends or any short and long-term capital gains realized ) paid from a mutual fund increase the basis because you pay tax on the distributions. That's how taxes on mutual funds work. Then when you sell mutual fund shares later, any distributions paid out already increase the basis because you already paid tax, you only pay tax on any additional gains.
Audrey
Hello,
Delurking because this caught my attention. I'm trying to decide if I'm reading too much into this, or if there's some issue I've neglected. My understanding was that MFs adjust their NAV when they give dividend or CG distributions. If you reinvest, your total value doesn't see it-- changes in NAV are counteracted by increased shares. If you don't, you *may* see the NAV lurch slightly. The tax paid on distributions is reflected by the drop in NAV (thus basis).

In the end, it's quite simple if I track every purchase/redemption (including reinvestments) with something like Quicken. I can easily use FIFO tax basis for sales of x shares of the fund by simply having Quicken report my basis for all purchases from the oldest up to x shares. The distribution-based taxes paid yearly in the past are irrelevant. That's useful if you believe FIFO is to your advantage and wish to harvest tax liability now-- taxes will go up, or low current tax bracket. It's a permanent decision for that fund made at the first sale, of course.

Would you agree with this, Audrey?
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Old 04-21-2009, 09:20 AM   #54
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Clifp, I wouldn't read too much into how Mr. Geithner's case was handled. It was, one might imagine, a "special" case. On the other hand, yes, the IRS is a pussycat compared to many state's tax boards (like mine).

As to capital gains, I increased my allocation to stocks at the lows and, mirable dictu, some things are up for the moment.

Back to the original question, I do not know what will happen in the future, but in broad strokes my strategy is to:

1) Tax loss harvest when appropriate and use the money to:
2) Increase diversity and/or rebalance into beaten-down funds.
3) Don't try to time the markets short term, yet watch valuations and:
4) Within reason, increase equity exposure at new lows.
5) Hang on for the long term, yet slowly ease back to normal levels as the situation improves.

During this crisis, I moved from a fairly basic total market approach to one somewhat more heavily weighted towards small / value, foreign, small-cap foreign, emerging markets, REIT's, etc.

We may not see a full recovery for many years, but things will improve.
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Old 04-21-2009, 09:38 AM   #55
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We're just rounding the corner to where our non-retirement (as in not in a 401k, 457, Roth) savings are getting significant enough to really start considering the impact of taxes and strategies to best avoid.

It's daunting to say the least.
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Old 04-21-2009, 10:37 AM   #56
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Is anyone but me concerned that the market will take a hit
when the bank stress test results come out? If I had any cash
to invest, I think I would hold it a little longer and wait for
a correction. After all, the runup from early November can't
keep going forever.

Cheers,

charlie
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Old 04-21-2009, 11:00 AM   #57
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The market has already priced these results into each bank's stock price. With the biggest banks reporting profits, I don't think the overall market's reaction will be driven by the specific results. That doesn't mean, though, that we won't see volatility -- as long as it isn't 20% a day, I'm relatively OK with that.

-- Rita
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Old 04-21-2009, 09:57 PM   #58
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Is anyone but me concerned that the market will take a hit
when the bank stress test results come out? If I had any cash
to invest, I think I would hold it a little longer and wait for
a correction. After all, the runup from early November can't
keep going forever.

Cheers,

charlie
I don't know much about these bank stress tests, but feel the same apprehension about the "impending correction". I don't know why you mentioned November low. The indices dipped lower in March 09 than in Nov 08.

Anyway, although my past attempts at market timing weren't that good, it did not keep me from trying again. Just sold some weaker stocks this morning to lower the stock AA from 60% to 50%. The market rose afterwards, and I would have a few more $K if I had left them alone. I will sit on my hands a while to avoid tweaking my AA too much.

On a positive note, I can brag that my portfolio value is back to the beginning of the year, while the Dow and S&P indices but not the Nasdaq are still a few percent down year-to-date.
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Old 04-22-2009, 06:40 PM   #59
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I ment to say "runup from early March" but had an attack of senility.

Cheers,

charlie
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Old 04-22-2009, 07:24 PM   #60
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The lesson for me this past year was to have a wider band like you! I ended up rebalancing on the downswing too often last year (twice, but that was once too often!). I had set a narrower AA range band so that under "normal" swift market corrections (10 to 15%) there would be enough of an out-of-balance condition to cause me to rebalance.

After this past year I've decided to wait for more extreme market events/stronger divergences before rebalancing. The other little market correction "opportunities" aren't so important.

Audrey
I'm not so sure that that was a good lesson to learn. That is, your strategy resulted in a bad outcome last year (just as mine did -- I rebalanced on Jan 3, 09), but with slightly different timing of the ups and downs, your strategy might have been ideal.

Next year a downturn of 8% might be followed by a 30% uptick, and then your older strategy would have been better.
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