Now that we’re approaching 31 days before the last trading day of 2018, it’s a good time to examine and/or temporarily pause/modify any automated investments to avoid triggering the wash sale rule.
If you aren’t familiar with TLH, it’s (at a high level) the practice of selling losing investments as a way of effectively decreasing your net taxable 2018 income come next April. The wash sale rule, among other things, disallows harvesting of losses if you bought a substantially similar investment within 30 days of the sale (in either direction). Thus, if at the end of this year you want to sell some lots that were purchased automatically, you would want to ensure no other automated purchases occur within 30 days of December 31.
Here’s a gentle introduction to help you out (targeted mostly at Vanguard, but applicable to others, too): www.bogleheads.org/forum/viewtopic.php?t=172568
Tax Loss Harvesting is a confusing topic for the beginner, but it doesn’t have to require a lot of work, especially if you are willing to sacrifice optimization for simplicity. Specifically, you can ignore the timing of dividend or capital gains distributions, you can buy and sell into funds with the same company (like Vanguard, or Fidelity or whatever), and, if you are a newish investor and all the shares in your Fund have lost value, then you don’t need to worry about using “specific id” as your cost-basis (for now). You can avoid even more complexity if you don’t rebuy for 61 days (Vanguard) or 91 days (Fidelity) in order to avoid the risk of paying a fee for too-frequent trading in a Fund. (Other companies might have other frequency-of-trading restrictions–but 91 days should cover the vast majority.)
There is some potential complexity you *cannot* avoid, however. If you have funds in more than one company, or in retirement accounts, you need to consider the possibility they will interfere with your TLH, as described below.
Here is a step-by-step guide for executing a tax loss harvest.
TERMS: Call the fund in which you have losses you want to harvest the Initial Fund. Call the fund into which you are moving the Alternate Fund.
IGNORE THIS STEP FOR NOW if you are a newish investor whose Initial Fund currently has a cost-basis method of “average cost” and you show losses in the Fund as a whole. Otherwise, go to your Account Settings in your Initial Fund and change the cost-basis method to “specific identification” of share lots. Note that this will take a day or two for the company to process. If you’ve previously sold shares from this fund before, then the remaining (old) shares will continue be treated as having one average cost. Only the new purchases will be priced individually. If you have never sold shares of this fund before, then all of your purchases since 2012 should be separated into lots and priced individually. If they are separated into individual lots, but they still show the same average cost after the switch to Specific ID, then your broker is Vanguard and you need to call and ask them to finish the job. (This seems to be a computer glitch and hopefully will be fixed soon.)
Why use “specific ID” instead of “average cost” going forward? It allows you to sell only those shares that have suffered a loss, which will result in more tax savings (and will increase the opportunities for you to TLH, since you don’t have to wait for the entire Fund to go negative–which hopefully doesn’t happen very often, especially after you’ve been investing awhile!). However, this switch *does* introduce complexity into the equation: after a partial sale of the Initial Fund to TLH, you will now own both the Initial Fund *and* the Alternate Fund simultaneously. This means that at the end of 31 days, if the market has gone up and you choose to keep the Alternate Fund to avoid paying short term capital gains taxes, well… you now have one more Fund to keep track of in your portfolio. And if the price does go down in the Alternate fund, it will also have gone down in the Initial Fund (since by design they are highly correlated). So now you would be in a position to TLH in *both* of these accounts… what new Alternate Fund do you select as the “new home” of the losing share lots from each fund? You’ll need to find another highly correlated, but not “substantially identical,” Alternate Fund that you’d be happy to hold long term. And so on.
In your account settings, switch from “automatically reinvest” dividends and capital gains, to depositing them into a Money Market fund at the same company. You can reinvest them 31 days after you tax loss harvest.
Ideally, you should not do your first tax loss harvest until at least 30 days have passed since your last purchase into the Initial Fund–that includes automatic payments, or reinvested dividends and capital gain distributions. But for simplicity, and if you aren’t willing to wait, TLH anyway. In the future, especially if you’ve permanently shut off automatic (re)investments, you can try to make sure that you make no purchases for 30 days before you TLH. What happens if you have a purchase within that window? It’s no big deal–it just means an equal amount of “harvested” losses will simply be disallowed as wash sales.
If you have any new money being automatically deposited into your Initial Fund(s), turn this off–you don’t want to accidentally buy shares in the Initial Fund for 31 days.
Beware if you have other accounts with substantially identical Funds, as these might trigger wash sales. If there are “substantially identical” funds in either your *or your spouse’s* other *taxable* accounts, you will definitely risk triggering wash sales. Any substantially identical Funds in you or your spouse’s *IRAs* (Roth or traditional) will also risk triggering wash sales. However, substantially identical Funds held in employer-controlled tax advantaged accounts (like 401(k)s, 403(b)s, or 457(b)s) probably will *not*. Probably. There has been no explicit guidance on this issue from the IRS and there are differences of opinion on bogleheads. Many bogleheads go ahead and TLH without worrying about the risk of triggering wash sales from whatever they holding in their employer-sponsored tax-advantaged accounts. But if you want to be super safe, make sure that any Funds in your other accounts (*all* of them) are not substantially identical to those in your taxable accounts that you are about to TLH; then you will ensure no conflicts (but you will also be adding some complication and work). Another safe move is to discontinue automatic investments into these tax-advantaged accounts for 30 days before and 31 days after the TLH–but for obvious reasons, for most people this is not a reasonable solution.
So what counts as a “substantially identical ” fund? The IRS has also failed to give good guidance on that, but see Step 4 for some basic advice.
In the simplest case, sell your entire position in the Initial Fund, and buy the Alternate Fund. More complex case: if you have “specific id” of lots and only some of your lots are in the red, then sell the ones that register losses but not those that have registered gains, and buy the Alternate Fund. Make sure this is done the same day (one easy one to ensure it: pressing the “exchange” button instead of doing a separate “buy” versus “sell”). Hold the Alternate Fund for 31 days (or more–if the market goes up, you might be staying in the Alternate Fund for a year in order to avoid paying short term capital gains if you switch back, or even forever if you never want to pay long term capital gains).
Some good exchanges (including vice versa) for funds in Vanguard:
VTSAX, VTSMX –> VLCAX or VFIAX or VLACX (Note: Holding VSMAX and VLACX at 12%/88% ratio approximates Total Stock Market. Useful if you end up keeping the Alternate Fund for the long haul.)
VTIAX, VGTSX –> VFWAX
VGTSX (Total International Stock Index) –> VFWAX (FTSE All-World ex-US Index Fund)
VBTLX –> VBIIX
The guidelines are that if the Initial Fund and the Alternate Fund track different indices (even if the indices themselves are highly correlated), they are not “substantially identical.” How about if they track the same index, but are in different companies? Arguably, they are not “substantially identical,” because they have different managers, different expense ratios, and probably at least a few different stocks. On the other hand, they might also be substantially identical, since these differences might be fairly meaningless when it comes to returns and risk. Again, the IRS has not told us. Google “tax loss harvest” and the names of the funds you are buying and selling, and you’ll probably find more suggestions than the above.
If the Alternate Fund has stayed flat or gone down, then sell the Alternate Fund, then (re)buy Initial Fund on Day 31 or later. Note: rebuying is optional. You should obviously do it if the Alternate Fund has gone down and you sold 100% of your position in the Initial Fund at Step 4–then you get to TLH again back into the Initial Fund (just make sure you don’t buy any more in the Alternate Fund for 31 days!). If the Alternate Fund has gone up substantially, though, you might want to stay in the Alternate Fund for a year (or forever) in order to avoid paying short term capital gains tax. (Make sure, therefore, that the Alternate Fund is one you could live with long term.) What, though, if you sold only part of your position in the Initial Fund? Now you own both it and the Alternate Fund, and *both* will have gone down. If you want to fully TLH again, you need to find a *third* fund that is highly correlated with the Initial and Alternate, but not “substantially identical” to anything else you own. Then just wash, rinse, repeat.
Switch back to automatic reinvestment of dividends and capital gains (or not. If you’re going to be a tax loss farmer you should probably leave it off). Switch back to automatic investments of new money (or not–again, your choice–but if you want to avoid problems, leave it off).
That’s it! You can get fancier when you learn more. This thread will give you lots of guidance, including directing you to the appropriate IRS publications: viewtopic.php?f=1&t=25268&newpost=2604938.