Tax-Loss Harvesting For Buy & Hold Mutual Funds and ETFs

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Always the procrastinator, I finally sold some shares of my punished mutual funds and ETFs in order to do some tax-loss harvesting. There are only two days left in 2008!

What is Tax-Loss Harvesting?
The main idea of this tactic is to legally pay less taxes by taking advantage of the fact that losses are taxed at potentially different percentages than gains are.

The IRS lets you claim a deduction for investment losses against your ordinary income, up to $3,000 each year. (If your net capital loss is more than this limit, you can carry the loss forward to later years.) For example, if you lose $3,000 on an investment, and you realize that capital loss by selling the stock or fund that incurred the loss without realizing any capital gains in the same year, you can claim a $3,000 deduction on your income tax return. This means you won’t have to pay income tax of up to 35% on $3,000 of your income that you would’ve had to pay otherwise.

On the other hand, a realized capital gain of $3,000 which you held for at least a year would only be taxed at a maximum of 15%. Therefore, although losses are still undesirable, if we plan on holding the investment for at least another year, we should “harvest” all the losses we can get.

Expanded Example

Taken and edited slightly from a older post:

Scenario #1: You are in the 28% tax bracket. Say this year you bought $10,000 of IVV, an ETF that tracks the S&P 500. In 2006 it drops to $9,000, and in 2007 it rebounds to $11,000 and you sell. You’d have a long-term gain of $1,000 from your original $10k, so you pay 15% in taxes ($150), and end up with $10,850 in your pocket. Net gain of $850.


Scenario #2: Same 28% tax bracket, same start period. You buy $10,000 of IVV, and in a year (2006) you sell at $9,000, and the very same day you buy IWB, an ETF that tracks the Russell 1000 Index, but is very similar (but not identical) to the S&P 500. Since it tracks very closely, your $9,000 of IWB in 2006 will also rise back to $11,000 in 2007. After a year and a day, you sell your IWB for $11,000.

Now in 2006, you had a capital loss of $1,000 from your IVV. So you deduct $1,000 from your ordinary income taxed at 28% and save $280 in taxes. That’s $280 in your pocket. Then, in 2007 you realized a long term capital gain of $2,000. You pay your 15% tax ($300) and you end up with $11,000 – $300 = $10,700. Add in your $280 from the last year, and you end up with $10,980.

This time, even though you had basically the same level of market risk, you obtained a net gain of $980.

Substantially Identical?
Note that you must do this with similar, but not “substantially identical” investments. For example, you can’t buy IVV back again right after selling it and try this. That would be called a ‘wash sale‘ by the IRS.

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  1. For those who plan a little you can get around the wash sale rule.

    You can actually buy the same stock/fund, but in order to avoid the Wash Sale rule you must wait 30 days before repurchasing.

    You can also work this in reverse. Say you hold something that has lost value, but you expect it to rise over your long term holding period. Simply buy some at the lower price, and then after 30 days go by sell the original shares that had lost value. Obviously this takes some tracking and watching from your end.

  2. Where did the $330 come from? Did you mean $280?

  3. Bill – Excellent point. If you leave yourself “out of the fund” for 30 days, you risk losing some potential gain (and also avoid potential loss). You could also buy a replacement for only 31 days, but that would result in potential short-term capital gains tax at your ordinary income rate again.

    Kevin – Good catch, fixed.

  4. You are off by $50. The entire gain comes from the difference in tax rates (although for long-term investing there is also the benefit of having more to invest earlier), so in this case it would just be 13% of the $1000, or $130 extra.

  5. You might want to mention that this the deduction is capped at $3000 per year for join filers.

  6. ETF’s are not as safe as they seem and are not as open and clear either. I was investing in a leveraged etf to find out it resets itself every so often so for longterm growth you end up leaving your chances to the company that manages the ETF.

  7. So, if you lose more than 3K you can carry it over year to year? So, for joint filers, the maximum amount for a typical 60 year investing lifespan is $180,000 in today’s dollars whether you do the sale in one year and carry over, or could somehow in theory sell at a $3000 loss per year?

    In sum, can I lose 180,000 in a tax year and carry it over each year for 60 years chipping away at my total?

  8. This is a really good tip.
    If I’m wrong here someone correct me, but I believe it cannot be used in a tax free (401k/IRA/etc.) account? Just mentioning in case someone gets excited and wants to try that.

  9. Yes. Although hopefully you will have some capital gains over the years, and there is no $3k limit for that. But you pretty much won’t have to pay capital gains tax for ever. Which is nice if the rate is raised from 15% in the future, which seems to happen every so often. Or they may increase the $3k at some point; it hasn’t changed for 20 years or so.

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