Tax Loss Harvesting - One Way To Save Money on Taxes in 2022

Hello folks,

I have a fun, potentially tax-saving post for y’all today. When markets fall, some are very understandably distraught and/or frightened. However, if you are a reader of this blog or a fellow Boglehead, you'll know there's little to worry about, as you can just dollar cost average in volatile times. And there are those of you that are looking for exciting strategies to deploy in a down market. This post is for you!

Today, we're going to be saving money on taxes by exchanging one index fund for another in a taxable brokerage account. Recently, I did this as well, and with a few clicks of a mouse, I will be saving thousands of dollars on taxes. This is something that you can do, too!

If you have a few thousand dollars in a taxable brokerage account, then you might want to continue reading to reduce your tax burden this year.

Why does this not apply to 401(k), Roth IRA, or traditional IRA? This is because you can't deduct losses in these accounts.

Before we dive into tax loss harvesting, I’d first like to talk a bit about what's called a wash sale with a hypothetical example.

Let’s say you made $70,000 from your W2 job this year. Let’s also say you have $40,000 worth of VTSAX in your taxable brokerage account, which was purchased as a lump sum (200 units bought at $200 per share) five years ago. I'm using hypothetical numbers here; it doesn’t matter when or how you bought; I’m just using this for simplicity's sake. As a third hypothetical, let’s say the stock market dropped 50% over a few months and now your $40,000 of VTSAX is worth $20,000. This means your 200 units of VTSAX, is now priced at $100 per share down from $200 per share. If you sold this stock and bought it back immediately, you’d be able to claim a loss of $20,000 allowing you to offset capital gains, take a capital loss of $3,000 (reducing your taxable income), and carry over the rest of your loss to following years. You’d still have the same 100 units you did before. The amount of stock you hold has not changed. You really haven’t lost anything other than $20,000 on paper. At a minimum, you’d reduce your taxable income by $3,000 to $67,000 meaning you would pay less in taxes.

However, this is NOT allowable due to the 'wash sale rule.' You are not allowed to sell and buy back the exact same stock/index fund immediately and claim a loss exactly for this reason. You'd have to wait 30 calendar days (31 days to be on the safe side) if you wanted to buy back the exact same stock or index fund.

But you ARE allowed to buy a different stock/index fund. If we were talking about individual stocks, you could sell a share of Google for a loss and use the proceeds to buy Apple stock. However, if you are a reader of this blog, you’ll know I don’t buy individual stocks. I keep it simple and just buy low-cost market cap weighted index funds, like VTSAX, FSKAX, and SWTSX.

In our scenario, you can sell your VTSAX, which tracks the CRSP index and immediately buy an index fund that tracks a DIFFERENT index like the S&P 500 (VFIAX). This IS totally allowable by IRS.

Once again, physicianonfire has a great guide to explain how to do this at Vanguard, and this is the same guide that I followed. You can find this here.

There are two really important things to note.

• You should change all of your dividends to reinvest manually. This is so that you don't accidentally purchase shares of the same index fund that you are selling (VTSAX) if your dividends reinvest automatically into the same fund in a different account (like a Roth IRA). If you're like me, you have several accounts at different brokerages, and the funds in your accounts may issue dividends on different dates or a different number of times in a year.

• Secondly, you'll want to change your method of selling to Specific Lot ID. This allows you to sell specific lots at a loss rather than your stocks being sold on a first-in-first-out (FIFO) or last-in-first-out (LIFO) basis. This allows you to sell specific numbers of shares that you bought at a specific price on a specific date. This change usually takes about a business day to flip over at a Vanguard.

Yes, from a 40,000 foot view, all you are doing is readjusting your basis, so you now have a lower basis. You will have to pay more taxes on your shares if you sell down the line. However, if you die without selling these shares, the basis will reset when your children inherit these shares due to the step-up in basis. Although, this is a bit of a tangent, since this relates more to estate planning.

For the uninitiated, 'cost basis' refers to the price that you bought the stock at. For example, let's say you bought 15 shares of VTI on January 5th, 2018 at $140 per share. The cost basis is the $140 per share.

Summary

1. Change all your dividends to reinvest manually for all accounts so no mistakes are made. You want these distributions to remain in a cash position or be distributed to a money market fund.

2. Change your sell method to Specific Lot ID at your brokerage.

3. Ensure that you do not buy the fund (VTSAX) that you want to sell 30 days before or after your sell date. If you bought that fund today (VTSAX), wait 30 days. In the interim, you can buy the fund that you will be exchanging to (VFIAX).

4. Instead of dollar cost averaging into VTSAX during this 60 day period, just dollar cost average into VFIAX.

5. Sell VTSAX and incur a "loss" and use the proceeds of this loss to purchase VFIAX.

6. Continue to not buy VTSAX for another 30 days. Buy VFIAX during this 30 day period.

7. After 30 days, congrats! You are free and clear to continue buying VTSAX and increasing the size of your position.

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Disclaimer: The article above is an opinion and is for informational/educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The author has taken care in writing this post but makes no expressed or implied warranty of any kind and assumes no responsibility for errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of the use of this information.