This post is part 2 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
- Part 2: executing the tax loss harvest (you are here)
- Part 3: what to do after tax loss harvesting plus advanced tips
From Part 1 of the guide, you should have a solid understanding of the concepts that make tax loss harvesting advantageous. It’s now time to move beyond the concepts and execute on tax loss harvesting opportunities.
Step 1: Check if You Have a Tax Loss Harvesting Opportunity
You have a tax loss harvesting opportunity if you have shares in the red that you can sell without triggering a wash sale.
Shares in the red
“Shares in the red” means that you must have funds that have decreased in value since you purchased them and thus can be sold at a loss. Since you switched to specific identification cost basis in Part 1, you do not need to have a loss for your entire holding in the fund. You only need a loss on one lot to have a tax loss harvesting opportunity.
For example, let’s say you’ve made 3 purchases of the Vanguard Total International ETF, VXUS. It is now 3/2/2020, and the price of VXUS has declined. You’d like to see if you have any tax loss harvesting opportunities.
With a current price of $50.08, the lots 1 and 3 now have losses since they were purchased at $55.63 and $55.08, respectively. Lot 2 does not have a loss since it was purchased at $49.97. By selling lots 1 and 3, a total of 190 shares, you can realize a loss of $1,025.
Can sell without triggering a wash sale
Besides checking for lots with losses, you must also check if selling your shares will trigger a wash sale (see Part 1 for an overview of the wash sale rule). This means you cannot have bought the fund you are looking to sell or any substantially identical fund in the 30 days prior to the date you are selling. For example, the following would trigger a wash sale.
Ideally, you would have recognized your tax loss harvesting opportunity on 2/28/20 and refrained from buying more shares. But what if it’s too late and you already bought within the past 30 days, meaning selling would trigger a wash sale?
You have 3 primary options:
- Wait until 31 days after you bought and see if you still have a tax loss harvesting opportunity. This is recommended for beginners.
- Sell the shares you recently bought to avoid a wash sale. This is situational and a bit complex – see Part 3 for more detail.
- Continue selling only the shares with a loss and trigger a partial wash sale. This must be reported on your tax filing so is only recommended for those with an advanced understanding of tax loss harvesting. See Part 3 for more detail.
When to check for TLH opportunities
In Part 1, you turned off automatic reinvesting of dividends and capital gains. That means you must now do this manually, likely at the same cadence you add additional savings. For example, I do this twice a month after I get my paycheck. This is the perfect time to check for tax loss harvesting opportunities.
I also recommend setting a threshold of a capital loss that is worth your time to harvest. If you have a $5 unrealized loss, it’s not worth the effort to sell and move money into another fund to save $2 on taxes. I set my personal threshold at $500, so if I see an opportunity to harvest $500 or more in capital losses, I will take it.
Step 2: Identify Replacement Shares You Will Buy
To avoid a wash sale but maintain your desired portfolio asset allocation, you must find an alternative fund that is similar but not “substantially identical” in the eyes of the IRS. This alternative fund should have the following characteristics:
- Has returns that are very closely correlated with the original fund
- Tracks a different index, clearly illustrating it is not substantially identical
- You feel comfortable holding the fund indefinitely – if you see gains in the next 30 days, you won’t switch back to the original fund due to tax consequences.
Based on the above criteria, I have assembled a list of logical alternative funds. These are the funds I use in my own portfolio to take advantage of TLH opportunities.
These are all ETFs, not mutual funds. ETFs are superior for tax loss harvesting because they are freely available for purchase across brokerage companies. Also, I included both equity and bond funds. While tax loss harvesting is typically done with equity funds due to their volatility, you should look for any opportunities to TLH bond funds, as well.
Step 3: Sell Your Shares that have Losses
It’s now time to sell your shares in the red and realize your capital losses. Once this is done, you will be able to use these losses to lower your tax liability.
When selling for tax loss harvesting purposes, it is important that you sell only the shares that have a loss. You must specify these shares when executing the sale on your brokerage website and avoid using the default selling method that is set up on your account. The exact mechanics vary by brokerage, so check out the specific pages for executing a tax loss harvest at Fidelity or Vanguard.
In case you’re not too familiar with buying or selling ETFs in a brokerage account, ensure your order type is set to “Market” so your sell order executes at the currently available price.
Step 4: Buy Your Alternative Fund Shares with Your Newly Available Cash
After your shares in the red have been sold, you’ll have money available to buy shares of your alternative fund. Although this may be a fund you haven’t previously invested in, this step is no different than any other time you purchase new shares. Again, the exact mechanics vary, so check out the specific pages for Fidelity or Vanguard.
Step 5: Avoid a Wash Sale after Tax Loss Harvesting
Congratulations! You’ve now successfully completed a tax loss harvest. You have realized losses you can use on your tax return this year, and your portfolio’s asset allocation is virtually unchanged.
The last step is to not screw up the work you’ve done so far. You must ensure you do not buy shares of the fund you harvested (sold) until 31 days after the date you sold it. The easiest way to do this is to simply wait 31 days to invest more money. At that time, you can see if your alternative fund increased or decreased in value and determine what fund to purchase and whether you have an additional TLH opportunity.
See the pages below for step-by-step instructions to execute a tax loss harvest at the two largest brokerage companies, Fidelity and at Vanguard.
- Fidelity step-by-step instructions to execute a tax loss harvest
- Vanguard step-by-step instructions execute a tax loss harvest
For more information on what to do after tax loss harvesting and some advanced TLH tips, see Part 3 of the Tax Loss Harvesting Step-by-Step Guide for Beginners.