This post is part 1 of a 3-part series providing a comprehensive tax loss harvesting guide for beginners. In this guide, I give an overview of tax loss harvesting, explain why it is important, and provide a step-by-step walkthrough of how to execute it, including screenshots from the two largest brokerages of Fidelity and Vanguard.
- Part 1: tax loss harvesting background and account preparation (you are here)
- Part 2: executing the tax loss harvest
- Part 3: what to do after tax loss harvesting plus advanced tips
What is Tax Loss Harvesting (TLH)?
Tax loss harvesting is the act of intentionally selling funds at a loss to realize a tax advantage.
If you sell a fund at a lower price than you bought it, that is considered a capital loss. Normally, losses are bad. You want your investments to grow, not shrink. However, experiencing losses at some point is inevitable, and you can make the most of those losses (especially during big market downturns) to lower your tax obligation.
The basic idea behind tax loss harvesting is that when a fund’s price dips below the price you purchased it for, you can sell it and shift the money into a similar fund. This gives you a realized capital loss for tax purposes while still maintaining your desired asset allocation with the new purchase. The advantage of doing this is that capital losses offset capital gains in a given year, and excess losses can be deducted from your taxable income (up to an annual limit). Losses above that cap can be carried forward perpetually to reduce income in future years, meaning realized capital losses can lower your income taxes for years to come.
Here’s a simple example of tax loss harvesting:
In this example, you bought 100 shares of Vanguard Total Stock Market (VTI) in January for a total of $16,600. In mid-March, the market took a sharp drop, and the value of your 100 shares was now only $12,106. To save on your taxes, you sold your $12,106 worth of VTI and immediately bought $12,106 worth of ITOT, a fund that is very similar but not identical to VTI. Because of this, your portfolio hasn’t really changed, but you now have about $4,500 in realized capital losses.
Assuming you have no capital gains, you can deduct a max of $3,000 from your income this year and carry forward the extra $1,500 to next year. If your marginal income tax rate is 40%, that means you just saved about $1,800 in taxes across two years. This is one of the only ways in investing you can increase your returns without taking additional risk, so it’s a powerful technique.
Because tax loss harvesting is all about reducing your tax liability, it is only useful in regular taxable investment accounts, not retirement accounts like IRAs or 401ks.
Tax Loss Harvesting Cost-Benefit Analysis: Is It Really Worth It?
If you want to maximize your investment returns, you must take advantage of tax loss harvesting opportunities. TLH takes a bit of research to understand, but the positive impact on your portfolio is well worth it.
The benefit of tax loss harvesting, reducing your tax liability, comes from two underlying reasons:
- Realized capital losses can reduce ordinary income (up to an annual cap of $3,000), which is taxed at a higher rate than capital gains.
- Money in your pocket today (from paying less in taxes) is worth more than money in the future. As a wise accountant once said, a tax deferred is a tax avoided.
Of course, a lower tax bill is great, but how much of an impact does tax loss harvesting really have? Investment services firm First Quadrant performed a study to answer that question. They simulated returns for 500 assets over 25 years, measuring the difference between portfolios with a simple buy-and-hold strategy and those that took advantage of TLH opportunities. They found that, on average, the TLH portfolio ended up 14% larger, after tax. By leveraging tax loss harvesting, you are growing your net worth by an additional 14% without taking any additional risk.
Clearly, the benefits of tax loss harvesting are significant. And there is only one cost: it takes more involvement from you, the investor. You don’t need to be a professional money manager to leverage TLH, but it is not a simple concept. It takes some time and research to understand the principles and how to execute in your specific scenario. With this guide, I am hoping to reduce your research time and help you execute tax loss harvesting for the first time. After you do it once or twice, it should only take 15-30 minutes each time in the future. That is a solid tradeoff for an extra 14% in your portfolio.
The TLH Complicating Factor: The Wash Sale
The main reason tax loss harvesting can be tricky is an IRS rule called the “wash sale.” The wash sale rule is the IRS’s way to prevent investors from getting a tax advantage when they don’t have “real” losses. The complicated part is determining what “real” losses are. Revisiting our TLH example from earlier, what if you simply rebought VTI instead of switching to ITOT? After all, it is much simpler to stay in the same fund.
Because you repurchased the same fund that you sold, this is considered a wash sale, and you are not able to recognize your capital losses for tax purposes. The official text of what constitutes a wash sale is in 26 U.S. Code § 1091. In essence, a wash sale occurs when you sell shares of a fund at a loss and, within 30 days before or after the sale, you buy substantially identical shares.
There are two main elements to unpack from this rule:
- It applies to fund purchases made with 30 days before or after the sale. This eliminates a loophole that could be exploited by swapping the order of the buy and sell. In the above example, if you bought 100 more shares of VTI, bringing your total share count to 200, and then immediately sold 100 shares to reduce your holding to 100 again, you would have a wash sale.
- During this period, you cannot purchase substantially identical shares. “Substantially identical” is a nebulous term that has not be well-defined by the IRS. Here are what the tax experts say:
- ETF and mutual fund version of the same fund (e.g. VTSAX and VTI) – probably substantially identical
- Two different company ETFs tracking the same index – maybe substantially identical (tax experts have differing opinions)
- Two funds tracking different indexes – probably not substantially identical and a good candidate for an alternative fund. See Part 2 for my list of solid alternative funds to use.
The wash sale rule applies across all taxable accounts and IRAs owned by you and your spouse, not just the account you have a loss in. However, the IRS has not clarified whether employer-sponsored plans like 401ks need to be considered. Many investors assume they do not and ignore purchases in their 401k accounts. This makes tax loss harvesting much simpler, but if you want to be super safe, you can also consider your employer-sponsored accounts when seeking to avoid wash sales.
While you should try to avoid wash sales because they offer you no financial benefit, rest assured that they are not illegal. If you accidentally trigger a wash sale, you will need to report it as such on your next tax return to ensure you don’t benefit from the capital loss that cannot be recognized.
Prepare Your Account to Best Enable Tax Loss Harvesting
Before you tax loss harvest for the first time, there are a few changes you should make to your account. These changes will ensure that you can capitalize on TLH opportunities more frequently and avoid wash sales.
1. Switch your cost-basis method to Specific Identification (Spec. ID) for all of your investments
By default, your cost basis will likely be “average cost,” which provides a simple view for beginning investors. It has only one cost per fund, which is the average of the various prices you purchased at. Specific identification instead provides your cost basis for each time you bought shares, separated into lots. Here is a table illustrating the difference.
Using the specific identification cost basis, if the price of VXUS fell to $53.00, we would have a TLH opportunity, selling the first and third lots of shares. Using the average cost basis, we would not have a TLH opportunity. Specific identification allows you to only sell the shares that have suffered a loss, meaning you can harvest more frequently, as this example showed. This is especially true after you’ve be investing for a while and have shares with substantial unrealized gains.
Do this for your regular, non-tax-advantaged accounts for both you and your spouse. You can ignore all tax-advantaged retirement accounts, since cost basis does not matter.
2. Turn off automatic reinvesting of dividends and capital gains
Nearly all investment funds make periodic payouts in the form of dividends and capital gains. Index ETFs minimize this activity, instead reinvesting in the fund, but they still have small occasional payouts. By default, your investment account will likely use this payout to reinvest, buying more shares of the same fund. That regular buying activity can interfere with tax loss harvesting by causing wash sales.
To prevent wash sales and preserve your ability to tax loss harvest, you should turn off automatic reinvestments and instead direct these payouts to a money market fund. You can then manually invest this money according to your usual cadence. For example, I do this when I purchase new investments twice a month after receiving my paycheck.
Do this for your regular, non-tax-advantaged accounts as well as any IRA accounts for both you and your spouse.
3. Use ETFs rather than mutual funds (optional but recommended)
To take advantage of tax loss harvesting opportunities, you will be switching between similar-but-not-identical funds. ETFs make this much simpler than mutual funds, since you can easily buy ETFs from many companies in one brokerage account. For example, if you use Fidelity as a brokerage, you can buy ETFs from Fidelity, Vanguard, Schwab, Blackrock, and more without paying any trading fees. The same cannot be said for mutual funds. That is why my recommended alternative funds are all ETFs.
If you currently hold mutual funds that have unrealized capital gains, I would not sell them simply to prepare for tax loss harvesting in the future. Instead, I recommend to buy ETFs going forward and look for an opportunity when your mutual fund dips below your purchase price to TLH and switch to an ETF. Alternatively, if you hold Vanguard mutual funds, you can convert them to their ETF equivalent.
See the pages below for step-by-step instructions to prepare your account for tax loss harvesting at the two largest brokerage companies, Fidelity and at Vanguard.
- Fidelity step-by-step instructions to prepare account for tax loss harvesting
- Vanguard step-by-step instructions to prepare account for tax loss harvesting
Learn how to execute on a tax loss harvesting opportunity.