Capital Gains Taxes, Part 2   3 comments

Yesterday I gave you an overview of capital gains taxes. Long term capital gains (for stocks, mutual funds, and ETFs held for at least a year) are taxed at lower rates than standard income. This is how despite making millions, Mitt Romney only paid an effective tax rate of 14.1%.

Today, I’m going to cover a couple of more advanced concepts with regards to capital gains taxes: capital gains distributions from mutual funds, tax loss harvesting, and capital gain harvesting.

Capital Gains Distributions from Mutual Funds

When I introduced mutual funds I mentioned how Vanguard is very good at keeping capital gains to a minimum (and oftentimes, there are no capital gains distributions after a few years from fund inception), and that this is a desirable characteristic.

Because of the way mutual funds are structured, when a mutual fund sells assets, by law virtually all the gains have to be distributed to the investors. To maximize returns, an investor should reinvest these distributions. However, these distributions are taxable, which cuts into an investor’s returns. Now granted, some of these capital gains distributions can be long term gains as opposed to short term gains. But still, this is not ideal for the investor. Ideally, the fund doesn’t distribute these gains and reinvests them internally.

Now how does Vanguard manage to avoid capital gain distributions? I am not quite sure, but my best guess is that they use tax loss harvesting to build up a reserve of capital losses. Though I could be totally wrong. In the end though, how they’re doing it is not that important. What is important is that Vanguard is clever and able to avoid capital gains distributions.

Tax Loss Harvesting

Recall from my last post that you can deduct capital losses from your income. You will naturally be able to take this deduction if your investments have lost money when you go to sell them. However, you can also purposely realize a loss when your investments have done poorly to get the tax deduction. This is best shown through an example.

Suppose you bought 300 shares of VTSAX a few months ago, and now it has dropped $3/share. You could continue to hold the fund, as your IPS says, or you could sell it to purposely incur a loss. Now you have a capital loss of $900 that you can deduct from your taxes.

You do want to stay invested in VTSAX in the long term, so you would like to buy back your position in VTSAX. However, to be able to claim the capital loss on your taxes, you must avoid what is called a wash sale.

Wash Sale – A wash sale occurs when you buy back a substantially identical fund or stock within 30 days before or after the sale of such fund or stock (from the IRS perspective, you didn’t really sell your fund or stock). When this occurs, the amount that is bought back is considered a wash, and washed sales cannot be deducted from your income on your tax return.

Now unfortunately, the IRS has never given a clear ruling on what substantially identical means. Is the ETF version of a mutual fund substantially identical? Probably. Are two funds from different companies tracking the same index substantially identical? Maybe. Are two funds tracking different indices substantially identical? Almost certainly not, but again, the IRS has never been clear on the definition.

So, you have two options when you tax loss harvest: buy a fund that tracks a similar index, or sit out of the market for 30 days (ie, let it sit in your bank account). If you buy a similar fund,

  • You stay invested the whole time.
  • If the similar fund loses money in the 30 day waiting period, then you can harvest more losses when you switch back to your original fund
  • The similar fund could gain money in the 30 day waiting period.

But I prefer to just let it sit for 30 days because it’s much simpler. You don’t have to worry yourself about whether the temporary similar fund will be ruled “substantially identical,” or whether the similar fund’s value could rise or fall in the 30 day period. While we know in the long run, your broad market indexed investments will rise in share price, in the short term, it can be quite volatile and I’d rather not deal with that. However, I would not argue against somebody who invests in a similar fund for the required 30 days – this is just my preference.

Now what exactly is the value of tax loss harvesting? Essentially, it is an interest free loan from the IRS. The reason this is a loan is that when you buy back your original fund, you are buying it back at a lower cost basis than what you originally paid (assuming that the original fund does not make substantial gains in the 30 day window). So, with this lower cost basis, you will now realize a larger capital gain in the future when you eventually sell this fund.

However, there is a saying that a tax deferred is a tax avoided, because future money is worth less than money today (inflation). Additionally, there are two situations where you may never actually end up paying the taxes on the larger capital gain.

  • If you donate these shares to charity, the charity can sell them tax free. Hence, you don’t realize a capital gain (and the charity is indifferent to the lower cost basis).
  • If you leave these shares to your heirs, your heirs receive them with a step up in cost basis (the cost basis of the shares is the price of the shares at the date of your death)

Finally, one word of caution. Make sure that you are not tax loss harvesting if the capital loss would cancel a capital gain that wouldn’t be taxed. For example, assume that you are in the 15% marginal tax bracket, which has a 0% tax on long term capital gains. Suppose this year you experience some long term capital gains. These capital gains will not be taxed. You should not tax loss harvest any funds this year, because the losses from these funds will first cancel out your gains that wouldn’t have been taxed anyway (recall that your capital losses first cancel out capital gains, and then up to $3000 of any leftover losses can be deducted from your income).

Capital Gain Harvesting

Capital gain harvesting is like the opposite of tax loss harvesting. If you are in the 0% long term capital gains bracket, then you can sell assets with a long term capital gain for free, and then buy them back the next day. The reason you’d want to do this is you can raise your cost basis of your assets for free and hence will owe less tax in the future when you eventually sell this fund. Also, there is always the possibility that the 0% long term capital gains bracket may disappear from the tax code through legislation, so you should take advantage of it if you can.

When engaging in capital gain harvesting, remember to stay within the 0% LTCG bracket despite the proceeds of your sale. That is, your AGI should not exceed the limit for the 15% tax bracket. Otherwise, you will incur taxes on your capital gains. Also, you need to remember that most states do not have a favorable tax on long term capital gains, so while the LTCG is not taxed by the federal government, it will probably be taxed as normal income by your state if your state has income tax. If this is the case, then you have to consider the tax incurred by this capital gain vs the future taxes avoided by raising your cost basis. Unfortunately, this calculation depends on tax rates in the future. I really don’t have good guidance on this situation because of this large unknown. If you live in one of the states without income tax though, this is a pretty easy decision.

Note that there is no such thing as a wash sale for capital gain harvesting. You can buy the funds back the next day to lock in this free step up in cost basis.

Next up, the all important retirement accounts.


Posted January 14, 2015 by Fiby in Uncategorized

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