How to Manage Taxes Efficiently and Maximize Your Returns Year Around – Part 1


As tax season has come and gone it’s a good reminder to make sure that you use all of the tools at your disposal to maximize your investment returns and minimize your tax burden year around, and effective investing requires good tax planning. After all, you don’t want to have to shell out 15% to 40% of your earnings every time you realize a gain. In this post we will be outlining how to minimize your tax burden based on your trading activity without significantly changing the make up of your portfolio and staying invested throughout the year. We will learn how to turn market dips into tax saving opportunities. This approach is one of the tools that you can use to make sure that your portfolio always increases in value, and when it dips, you minimize your losses by taking advantage of tax breaks.

Tax Loss Harvesting

This strategy is commonly referred to as tax loss harvesting. Tax loss harvesting is defined as the process of selling a security to claim a loss for tax purposes, but at the same time buying a similar stock or security so that you stay fully invested and the make up of your portfolio stays basically the same. The best way to do this is to use ETFs or Mutual Funds that track similar, but not the same underlying index. For example, suppose you held 50 shares of the Vanguard 500 Index Fund ETF (NYSE: VOO) that tracks the S&P 500 index and you purchased them at $185/share leading to a total cost of $9,250. The ETF then dropped to $140/share which amounts to a paper loss of $2,250 (($185 – $145) X 50 shares). What you would do next is sell all of your shares of VOO to have a realized loss and use the proceeds of the sale ($7,000) to purchase an ETF that tracks a similar index such as the Schwab U.S. Large-CAP ETF (NYSE: SCHX) that tracks the Dow Jones U.S. Large-Cap Total Market index. The difference between the two underlying indexes in this example is that the S&P 500 index tracks the largest 500 domestic companies while the Dow Jones U.S. Large-Cap Total Market index tracks the largest 750 domestic companies based on market cap. Given that large companies are weighed higher the performance of those two indexes is virtually the same.

The result of the transactions in our example is that you are still invested in an ETF that tracks a similar index with the same amount of money that you would have had if you had just held on to the original ETF, however, you now have a $2,250 realized loss plus the trading costs that you can claim in your taxes. If the underlying index continues to decline you can find another ETF and repeat the process again, and in the event that the market recovers you will be holding an ETF that has appreciated in value while having been able to pocket a capital loss. The result of this approach is that you will cover both scenarios of the fund appreciating or declining in value.

Tax Rules

Current tax rules allow for a $3,000 deduction per year for realized losses, and anything above that can be rolled over into future tax years. For example, if you had $7,000 in realized losses this year you would be able to deduct $3,000 this year, another $3,000 next year, and the remaining $1,000 in the year after that. That means that you should harvest losses when ever possible since you can claim the benefit in future years when the stock market may be on an upward trend and the opportunity to harvest additional losses is no longer an option for you.

Wash Sale Rule

The reason to avoid using two funds that track the same underlying index is that it would likely trigger the wash-sale rule disallowing the tax loss. The wash sale rule was written long before sophisticated securities like ETFs were introduced and is a gray area of the tax code that can disallow this tax loophole. The rule states that:

You cannot deduct losses from sales or trades of stock or securities within 30 days before or after the sale if you:

  • Buy substantially identical stock or securities
  • Acquire substantially identical stock or securities in a fully taxable trade, or
  • Acquire a contract or option to buy substantially identical stock or securities

The two key items for the wash sale rule are the 30 window where tax losses are disallowed, and the “substantially identical” term in the definition of the rule. Lets explore what your options to avoid those key items are.

  1. Waiting more than 30 days before you buy a security that you recently sold is an easy way to avoid the wash sale rule, however, the downside is that you may have sold the stock or security at a loss and that same stock or security could have appreciated in value in those 30 days. That means that you would have a realized loss, but you would not be able to purchase the same amount of shares you had previously because the price appreciated. For example, you purchased 50 shares of the VOO ETF at $185 per share. The stock then dropped to $145 at which point you sold the ETF realizing the same $2,250 capital loss as the previous example. In order to avoid the wash sale rule you wait 31 days before you purchase the VOO shares with the $7,000 proceeds of your sale, but during that time the share price rises to $155 per share. At that share price you are now only able to purchase 45 shares of the VOO ETF. The end result is that you have a $2,250 capital loss that you can claim for tax purposes, but at the same time you missed out on $775 (5 fewer shares X $155) in appreciation due to holding fewer shares.
  2. Substantially identical is a vague term that you can use to your advantage. As our example of trading ETFs that track different but similar indexes shows, you can sell ETFs at a loss while keeping an almost identical asset allocation that is made up of the same underlying securities. This approach allows you to avoid triggering the wash sale rule and you don’t have to wait 30 days before making the transactions.

Applying a tax loss harvesting strategy can be a key decision to managing taxes effectively. In part 2 of this post we will explore how to select ETFs or use stocks in conjunction with a value investment strategy to maximize tax savings.

Posted in Fundamentals

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