Seems I raised a few questions from my previous post where I mentioned tax loss harvesting. This information only applies to taxable investors. Tax-deferred investors can ignore this post.

You can also read about tax loss harvesting here:

http://www.bogleheads.org/wiki/Tax_Loss_Harvesting

http://www.getrichslowly.org/blog/2008/12/22/tax-loss-harvesting-how-to-use-the-market-downturn-to-save-on-taxes-this-year/

The basic idea is you sell off your losing asset to capture the losses and apply those losses against other gains and your annual income. You then buy back into the asset in a couple various ways to build your position back again to where it should be. This allows you to bank those losses as a credit that can lower your tax bill. It is easier than it sounds and can save you big bucks. If you have losses in your taxable investments and don’t understand this, talk to a CPA. It may pay for itself many times over.

Usually you can’t do much tax loss harvesting after the first few years because most assets will have developed too much in gains so there are no losses. But with the markets so volatile the last year or so this option has become more available to investors. You can use tax loss harvesting with stocks, bonds, gold and other assets that show a loss (check with your CPA for your situation). The IRS requires you to wait 31 days before buying the same asset again to avoid a “wash sale” (which would negate the ability to write off the losses) but this is easy to work around.

There are two ways to do a tax loss harvest:

1) Sell the losing assets and wait 31 days to then buy back in.
2) Sell the losing assets and use the proceeds to immediately swap into another fund which is a close representation of the asset, but NOT the same asset.

For instance: You have a loss in the Vanguard Total Stock Market portion of your portfolio. You sell off those shares and capture the losses. Then wait 31 days in cash and buy back in.

- Or -

You sell off your Vanguard Total Stock Market index and buy the iShares Russell 3000 index immediately which is a different form of the Total Stock Market, but moves nearly identically.

Advantages and disadvantages of each approach:

Selling and Waiting 31 Days

Advantages:

  • Easy to do.
  • You won’t have a bunch of different funds representing the same thing in your portfolio.

Disadvantages:

  • The asset could shoot up in price quickly during the 31 day wait and you miss out on the recovery.
  • If you use Vanguard, they will require you to wait 60 days to buy back into the same fund electronically. You’ll have to send them a snail mail order to do the purchase in 31 days.

Selling and Swapping

Advantages:

  • You won’t miss out on an asset recovery within the 31 days.

Disadvantages:

  • Your portfolio could get cluttered up with essentially identical assets covering the same purpose (e.g. Vanguard Total Stock Market, Vanguard 500, iShares Russell 3000 all do just about the same thing and you’d own a mix of them which is messy).
  • The IRS may view your swapping of funds as a wash sale if they are too identical in type (e.g. swapping Vanguard Total Stock Market for iShares Russell 3000 may be OK, but in the future the IRS may rule it is not OK).

Personally, I just sell and wait 31 days. It’s simple and avoids IRS gray areas. It’s a coin flip whether this will be good or bad for you. Since you will be sitting in your super safe Treasury Money Market fund with that cash you won’t get hurt too badly in all likelihood no matter which way it works out.

Recently I’ve harvested and it saved me from new losses as the asset (stocks) continued to go down over the 31 days (in late 2008). Then I’ve done it (stocks again) and the asset went up over the 31 days so I lost out a little on gains (2009) but not enough to overcome the losses I had taken so it was still a good deal. Whereas in 2008 if I had done the fund swap trick I would have gone from taking losses in one stock fund into taking immediate losses in the swapped stock fund. In this case the 31 day break helped me avoid new losses that were still going on in the market. Again though, it could have just as easily been the case that the markets recovered during that time. You really just don’t know what will happen which is what makes this stuff just so much fun, right?

The idea though is you sell off only those assets with enough of a loss to make it worth your time. Also there is a subjective judgment call involved in all of this. If you own some shares of Total Stock Market that show a loss of -1-2% or so I wouldn’t do a tax loss harvest. The reason is that over the 31 day wait it’s entirely likely that they could recover and wipe out that loss. But if you have something with -10% or more loss I will harvest it as it’s unlikely you’d see a 10% recovery in a month. It’s not impossible mind you, just not as likely. Between the -2%-10% loss range it’s going to be a crapshoot. It may work out or may not.

One important thing: If you reinvest your interest and dividends you could trigger an unintentional wash sale if that purchase happens automatically during your 31 day wait period. So my advice is to just have your funds deposit interest and dividends into your cash allocation and manually redeploy the funds into lagging assets.

Also, consider that you probably shouldn’t do an asset swap with something like Treasury Bonds or Gold as you’d likely be swapping for another Treasury Bond fund or Gold holding and this is a little too close for comfort in the wash sale gray area. It’s probably best to wait the 31 days to be safe and just park that money in your Treasury Money Market Fund (Cash) allocation.

If the markets stabilize, tax loss harvesting won’t be an option except for perhaps new contributions to each asset class as losses will vanish across your entire portfolio eventually and turn into gains (hopefully!). So instead of being able to tax loss harvest on 100% of an asset, you may only be able to do it on a small percentage of recently bought shares that may have gone down in value. Eventually it may not be worth your time and effort once the gains get too large and the losses too small and tax loss harvesting just won’t be workable.

There are some other subtleties involved so you may want to talk to a CPA to find out what applies to your situation as I’m not a tax advisor. Tax loss harvesting may not work all the time, but when it does it’s a way to save on your tax bill and that’s money in the bank for you.

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