How to Manage Taxes Efficiently in 5 Steps

Financial Planning and Review of Year End Reports

Tax loss harvesting is a strategy to maximize your investment returns and minimize your tax burden. The strategy itself is easy to put into practice, but there are pitfalls you should be aware of to implement it successfully. In our previous blog post about managing taxes effectively we provided an overview of tax loss harvesting, and in this blog post we will go over how to implement it step-by-step. The approach outlined in this post can be implemented with either ETFs or Mutual funds, however, we will use ETFs in our examples since they are easier to trade and often have lower expense ratios than their Mutual Fund counterparts.

Step 1: Make a List of ETFs

The first step will be to make a list of ETFs that track similar, but not the same, indexes. As we explained in our previous post, if the ETFs that you use track the same index, they may trigger the Wash Sale rule disallowing the tax loss. The indexes that you decide to use will be up to you, but we recommend that you include a broad market index, an international index, and, if another sector of the market interests you, a specialty index like healthcare.

Different, but similar indexes can have the same underlying securities, costs, and perform almost the same. That is because the weighing of the stocks in each fund is tilted towards the largest companies in broad market ETFs. That means that the performance of the funds is largely driven by the same underlying stocks.

Finding ETFs that have similar indexes requires some research. You must first get a list of ETFs, read their strategies, and then compare the make up of their underlying index to assess how similar they actually are. For example, the table below contains Large Cap Value ETFs that each follow a different index, but when looking at the stocks within each one you’ll find a high degree of overlap in stocks and their allocation.

ETF Name Symbol Expense Ratio Index
Vanguard Value Index Fund ETF Shares VTV 0.08% CRSP US Large
Cap Value Index
Mega Cap Value Index Fund ETF Shares
MGV 0.09% CRSP US Mega Cap Value Index
Schwab U.S. Large-Cap Value ETF™ SCHV 0.06% Dow Jones U.S.
Large Cap Value Total Stock Market Index
iShares Core
Russell U.S. Value ETF
IUSV 0.07% Russell 3000 Value Index

A larger list of ETFs that follow similar indexes can be found in our recent post on 90 ETFs to Save On Taxes.

Guidelines to Follow

  • Keep An Eye on Expenses
    Make sure that the ETFs or Mutual Funds you target have low expense ratios. You don’t want to be in a situation where you hold a fund that appreciates significantly for a long time while the underlying fees erode away your potential gains. The ETFs you select should have expense ratios that are less than 0.25%. Many ETFs today have less than 0.10% and can trade without transaction fees in your brokerage account.
  • Review the Underlying Securities of the ETFs
    If you’re comparing ETFs that track different but similar indexes, take a look at the holdings that make up the ETF to make sure they really are similar. Looking at the top 10 holdings should be a good indicator as to how much similarity there is within the ETFs. If 8 to 10 of the top 10 holdings are the same or are in slightly different order that should be sufficient to pass the similarity test. Comparing the make up of ETFs is especially important for ETFs that track specialized indexes like health care, energy, etc. It’s possible that two specialty ETF’s both track the same sector but are vastly different in terms of their make up and their performance.
  • Compare the Performance of the ETFs
    The third thing you should check is to see if there is a high correlation in the performance of the ETFs you are considering. A good place to start it to compare the charts of the ETFs to get a visual representation of how closely they align. Yahoo finance charts will allow you to compare and eyeball their performance. You want to make sure you look for a very high correlation between the two ETFs. The following chart shows the correlation between the SCHX and VOO ETFs that shows a nearly identical performance.


    If the charts divert significantly at any point it means that there is an underlying security held in a significant amount in one ETF that is not present in the other. That should also be a warning sign that the ETFs you’re comparing might not be as similar as you might think.

  • Make Sure You Like the ETF and the Strategy It Follows
    It’s possible that you will holding the ETF for a long time. For that reason you should ensure that the ETF will fit into your overall investment philosophy. For instance, you wouldn’t want to hold an ETF that tracks a real estate index if real estate is not part of your core strategy.

Step 2: Purchase Initial Investment

Once you have your list of ETFs, the next thing to do is to put your plan into action and add the ETF to your portfolio. There is no sense in trying to time the market here; if the stock appreciates you should be happy to get a gain, and if it declines you can put your tax-loss harvesting plan into action. You can also purchase multiple lots of the ETF over time, however, you will want to confirm the accounting method your brokerage account uses to calculate your gain or loss if you don’t sell all of the shares you own at once. Some brokerage accounts use the First In First Out method (FIFO), or Last In First Out (LIFO), or some combination of the two.

Step 3: Calculate Your Break Even Point

The cost basis for the ETF will be the amount it cost to purchase it including transaction fees and will be what you use to determine what your potential loss will be in the future, should you sell the ETF. The break-even point should be included in the table of ETFs to make sure you have all of the information you need at a glance.

Step 4: Sell Funds to Realize a Loss and Buy Alternative Fund

In the event that you have held the ETF for more than 30 days and it drops in value below the break even point by a significant amount, you should sell your holdings to turn your paper loss into a realized loss. If the drop in price is small you should wait until the loss is more substantial. For that reason you should always have a minimum target loss when you buy an ETF. For example, if the ETF drops to the point where you have a $100 loss, that is not a sufficient amount of money to make all of the effort worth the trouble, however, if the loss is over $1,000 then it may make sense for you to harvest that loss.

Step 5: Repeat As Many Times As Possible

Once you’ve sold the original ETF and bought the alternative ETF to harvest a loss you can continue to repeat the process with your new ETF holdings. The same rules as before apply, so if the alternate ETF begins to drop in price to a point where it again makes sense to harvest the loss, you should take advantage of it and sell it. You could purchase a whole new ETF or purchase the original ETF that you previously held as long as you’ve met the holding period requirements.

Posted in Fundamentals

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