AssetBuilder Inc. Registered Investment Advisor - Simple Investing. Smart Future.

Scott,

Before the end of each year I hear encouragement to do TLH. Then I read in the forums (Bogleheads, M*, etc.) that it's such a good tool Uncle Sam gave people to use in their taxable accounts because as if TLH helps you increase your after-tax return. But I personally cannot wrap my brain around it.

In my mind TLH goes against LT investor mentality. Sure, I'm perhaps OK to sell a stock/fund that became a dog and I don't believe in its future anymore. So, I take my losses and invest somewhere else. But I read that people would sell some fund (like Vanguard Value Index) and immediately invest in Vang.Winsor II which are very alike. I'm guessing the latter fund must be trading low as well to have some benefit, right? But isn't this against LT investing? If they decided to invest in a fund for 10-20 years in the first place, why wouldn't they buy even more shares of Value Index when it's cheap or if not just keep it anyway? For me, TLH also sounds similar to market timing.

Is TLH more common among investors who invest in thousands at a time (e.g. $10k+ or $100k+) and not among us like me who do DCA'ing in small denomintations (less than $500/mo.)?

I made a hypothetical tax situation for our 2008 taxes. I predicted that our DODGX will have $1,400 LT cap.gains reinvested for us in 2008. Then, let's say I choose a DRIP like BAC to sell now which would generate also $1,400 in losses. I assumed LT losses here. So, my taxes would decreace by $40 only. It doesn't look like my TLH gave me a big benefit. So why not keep BAC and see what happens? Does this imply I'm in the lost aversion trap? OK, I agreen that BAC is not a good example, because it's an individual stock + becoming a dog. What about using VTSMX instead of BAC? Would it change anything in the above scenario?

E.g. I've been investing in DODGX for 4.5years now (taxable account). I chose it for LT. At the end of 2007 my cost basis was below its market price, but as of now we're in red. Well, I increased my weekly investments, but someone else might choose TLH and sell it and buy maybe some Vanguard Value fund. So, who's right/wrong or what's wrong with my thinking that I refuse to do TLH?

Your thoughts? If if you know of some simple/easy reading about TLH (book or website), please recommend.

Thanks so much. 

For most people, tax-loss harvesting is exactly what you perceive it to be--- a lot of effort for very little cheese. It can be very meaningful, however, for people in a high tax-bracket who are trying to control their tax bill as year-end approaches.

Suppose, for instance, that you are in the 34 percent tax bracket--- as lot's of Californians are due to the state income tax rate--- and you realized $10,000 in short-term gains during the year. Without a tax loss to offset that gain you'd be facing a tax bill of $3,400. But if your portfolio also had a $10,000 unrealized loss and you could reinvest in essentially the same (but NOT exactly the same!) security, then you could sell, realize the loss, and avoid $3,400 in income taxes.

Significantly, index investing can make this pretty easy. You could, for instance, substitute the Russell 1000 ETF for a Standard & Poor's 500 Index fund. You could also substitute the Russell 3000 ETF or Vanguard Total Market. As a result, you'd increase the tax efficiency of your portfolio with virtually no change in your long-term asset allocation.

Scott

Thanks for a quick response. It's good to hear that my perception was not totally wrong: chasing little cheese with lots of effort.

Hi Scott,

My wife and I are considering selling around $20,000 worth of MPGFX shares from our taxable account in order to put down a construction "earnest" deposit for a new home to be constructed (the builder will carry the construction loan but requires this good-faith deposit from us to be held in escrow...then used as part of our down payment in our new mortgage loan).  We have around $43,000 in this fund and could either sell shares with a higher cost basis (mostly bought in the past 2 1/2 years) to realize the loss and deduct from our 2008 taxes, OR we could sell shares with a lower basis (purchases from 2004-05) and pay the tax now.  We plan to replace this $20,000 in MPGFX once our current home sells and its equity is freed up.  Our AGI this year should be right around $159,000--the top of the income limit for full Roth IRA contributions; we are in 25% marginal tax bracket after all itemized deductions.

I see the pros and opposing cons as follows:

Sell higher cost-basis shares--PROS: realize the $2500 loss now; get the current tax deduction (around $500 tax savings); keep our AGI under the $159,000 so that we don't have to withdraw any of the Roth contributions we've already made; lower cost basis shares in taxable account continue to grow quasi-"tax-deferred"; current deduction will help lower this year's taxes before our taxes drop next year due to larger mortgage interest deduction

CONS--capital gains taxes might (likely) be higher in the future...resulting in the leftover low-basis shares being quite expensive taxwise down the road

Sell lower cost-basis shares--PROS: pay Uncle Sam (tax) today when tax rates are lower; overall cost basis of remaining shares is higher...lighter tax burden down the road

CONS--pay more tax today; may have to withdraw some Roth contributions

Third option: Sell the higher cost basis shares purchased within the past year (but not more recently than 30 days ago because of wash sale period) to maximize short-term capital loss deductions at 25% tax rate; and sell lowest cost basis shares to maximize long-term capital gain rate of 15%--a kind of cancelling-out balanced approach.

Spend 'til the End (chapter 36, p. 270) has me wondering what I should do.  Do you feel my analysis is good, and which would you recommend?

Thank you as always, Scott.

Bradley

Bradley,

Assuming you can sell by tax lot, I'd opt to pay the tax today as a kind of "investment" in less tax tomorrow because you've preserved the tax loss. The worst case is that your loss will disappear as the fund rises in value and you'll have captured the current low capital gains tax rate.

Here's how the math works, using your 20 percent figure for current tax savings. I've assumed two tax lots to illustrate. One is 100 shares purchased at 75 and now worth 50 for a $2,500 unrealized loss. The other is 100 shares purchased at 25 and now worth 50 for a $2,500 unrealized gain.

• If you sell the loss shares you'll save $500 on taxes this year. But the tax on the future unrealized gain, assuming a 25 percent future rate, would be $625. So your total tax bill will be $125.
• If you sell the gain shares you'll pay $500 in taxes this year. But the tax saving on the future unrealized loss, assuming a 25 percent future rate, would be $625. In this case your net tax bill would be a saving of $125. In effect, you are "investing" $500 of current tax payments to save $125 of tax payments in the future--- and you can defer that event for a good many years and it will still be a good "return."

The risk, of course, is that future tax rates won't rise. But that is becoming increasingly improbable.

Scott

Thank you, Scott.  I really appreciate it!

Bradley