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Tuesday, December 30, 2008

Tax Loss Harvesting

I can really tell that the end of the year is coming and the state of people's portfolios by the kind of questions I get. This year, the theme is tax-loss harvesting. In prior years, this wasn't much of an issue because people didn't have any losses to harvest!

Losses are first used to offset gains (i.e., gains are untaxed if accompanied by losses of equal amount). If there are any excess losses, those go against up to $3000 of earned income, and the remainder can be carried over to future years. [Update: I remember that it used to be that only long term losses could be used to offset income, but it looks like this rule changed out from under me]

Other things to watch out for:
  • When taking your losses, you might want to do so before the record date of the dividend payout. This reduces your income so you get taxed less, and actually doesn't cost you the actual dividend, since for most mutual funds, the net asset value (NAV) drops by the equivalent amount on the record date, so you might as well take the reduced capital loss rather than getting taxed on it.
  • When buying an equivalent equity holding, please note that VIPERs are considered equivalent to their mutual fund, so if you're selling VFWIX, you cannot buy VEU. That's because VIPERs are a specially carved out portion of the actual mutual fund. If you do this, you'll end up hitting the Wash Sale Rule, which will in effect zero out your capital loss.
  • It is OK to buy an equivalent fund that tracks a different index. For instance, you can buy VGTSX to substitute for the afore-mentioned VFWIX, and then switch back 31 days later. (It is generally better to hold VFWIX because of the favorable foreign tax-credit distributions treatment)
  • You can even split your fund and buy components (for instance, buying the Pacific, European, and Emerging Markets funds at the appropriate proportions), at the expense of making your portfolio more complicated.
  • When buying the equivalent fund, be careful to also avoid buying the dividend.
  • As mentioned before, turn off reinvestment of dividends and capital gains in your taxable accounts, so that you can do effective tax-lot account in the future.
  • If you're planning on being able to be selective about which tax losses you take, then ETFs are the right model for you, not mutual funds. Vanguard, for instance, makes it quite difficult to get lot-based accounting for sales, which makes such manipulations difficult --- I don't frequently run into these issues because I usually sell all or nothing in a fund I own

When looking at the wash of red-ink over your portfolio at the end of this year (unless you're actually making money, in which case, you should be blogging about money instead of reading my blog), there is one consolation, which is that all this money in your portfolio is effectively tax-free while you still have unrealized capital losses. While that's not something to be happy about, it does mean that your tax bills will be much lower in the years ahead. Given the likelihood of the Obama administration raising taxes (and yes, you can blame the unusually low tax rates in the last 8 years for at least some of that --- we could have used that money to run a budget surplus for problems such as the financial crisis), that's something you can be grateful about.


Unknown said...

I think you may be mistaken about only long-term capital losses being allowed to be offset against income (up to 3K/year). For example, the webpage at does not make that distinction.

Piaw Na said...

Hm... Looks like you're right! I must be remembering an outdated version of that rule.