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- Yield To Maturity Might Be Indicating a Bottom in the Bond Market - August 21, 2023
Today we’re going to go over a strategy that can be used to reduce your future tax bill on your investment portfolio, which just so happens to be super relevant right now: Tax Loss Harvesting.
What Is Tax Loss Harvesting?
When you’re still working your way towards your FI target, you’ll generally by only buying ETFs. Even if the market goes wonky and your target allocations go out of whack, you should be able to rebalance back to target by redirecting your monthly cash injections towards assets that have gone down. This is generally the right thing to do, because buying never triggers a taxable event.
Years later, when you finally pull the trigger on early retirement and ride off into the sunset cackling at your former boss, the situation changes. Now that you’re no longer putting money into your investment accounts and are instead pulling money out of your portfolio to fund your living expenses, you will be occasionally selling units. And when you do, you may have to pay taxes on the profit.
This tax is known as a the Capital Gains tax. Basically, here’s how it’s calculated.
Take the price that you sold your units at, then subtract the price you bought those units at (your brokerage should keep track of this for you as the “Cost Basis”), then multiply it by how many units you sold. This is your capital gain.
So for example, if you bought 1000 units of an ETF at $100, then years later after your retire, during a rebalance you sell 20 units of that ETF at $150, then your capital gain would be ($150 – $100) x 20 = $1000.
This capital gain would then get reported on your tax return and, depending on your post-retirement tax situation (i.e. whether you have side hustle income), this may result in tax owing on that amount.
But with some planning, it’s possible to offset that capital gain tax and potentially result in no taxes being owed. Here’s how.
The opposite of a capital gain is a capital loss. If you sell an investment for less than you bought it, you’ve realized a capital loss.
Capital losses are interesting in that if you report them on your tax return, you can use them to offset any capital gains you may owe. And if you don’t have any capital gains that year, those capital losses can carry forward into future years indefinitely.
So say you’re in the middle of an economic calamity, like say, a global pandemic. You’re looking at your portfolio and it’s a sea of red, with losses everywhere. One possible reaction would be to roll your eyes, angrily sigh, and go watch Tiger King on Netflix. Another would be to recognize that those losses are likely temporary and harvest them. If you do this, you will be able to carry them forward to a later date when they might come in handy in reducing your tax burden from future capital gains.
Interestingly, in the US, capital losses harvested in this way can also be used to reduce ordinary income, up to a limit of $3000 per married couple each year.
How Do I Perform Tax Loss Harvesting?
So how do I harvest these capital losses? Simple. You sell them.
But wait! Haven’t I been harping on and on that when times are rough you should hold onto your ETFs and never sell them at a loss? Well, yes, that’s still true. But harvesting capital losses isn’t just selling at a loss. You sell them, and then you immediately buy them back. This way, you’ve realized capital losses by your sale, yet you haven’t actually changed anything in your portfolio. You target allocation is still the same, and you’re still positioned to ride the inevitable recovery along with everyone else.
Two caveats to this maneuver though:
- Only do this in your taxable account. Capital gains and capital losses aren’t reported on tax-advantaged accounts like the 401(k) or the Roth IRA, so it makes no sense to do this in those accounts.
- Beware the Wash Sale Rule
Uh-oh. What is the Wash Sale Rule?
The Wash Sale Rule is a rule implemented by tax authorities to disallow exactly what we’re attempting to do here. The rule states that if you sell a stock at a loss, and then re-buy the exact same stock within 30 days, then the capital loss is disallowed and cannot be used to offset future capital gains.
The trick, though, is that the Wash Sale Rule only disallows capital losses if you sell and then re-buy the exact same stock. If you buy a similar stock with a different ticker symbol, the rule doesn’t apply because it’s not the exact same stock!
For active investors that buy individual stocks, they’ve taken advantage of this loophole by selling stocks from one company at a loss, then re-buying a highly-correlated stock from another company. For example, they’d perform a tax loss harvest by selling stock units of Bank of America, for example, and then re-buying Wells Fargo. These are two very closely related stocks that generally perform very similarly to each other, but since they’re two different companies the Wash Sale Rule doesn’t trigger and the capital losses are allowed.
It’s even simpler for us index investors. To get around the Wash Sale Rule, all we have to do is just switch to another ETF that tracks the same index but is run by a different company. Even though under the hood, the funds are 99.9% identical, because it’s run by two seperate companies they cannot be considered the same and therefore the Wash Sale Rule doesn’t get triggered.
For this reason, I like to keep a list of “shadow” ETF for each holding in my portfolio. These are alternative ETFs that track the same index, but are run by another company and therefore trade under a different ticker symbol, and whenever I need to harvest capital gains, I just switch to the shadow one, and then 30 days later (or whenever I remember), I switch it back.
For the Canadian workshop portfolio, here is my shadow ETF list.
| ETF | Description | Shadow ETF | Description |
|---|---|---|---|
| VAB | Vanguard Canadian Aggregate Bond Index ETF | ZAG | BMO Aggregate Bond Index ETF |
| VCN | Vanguard FTSE Canada All Cap Index ETF | ZCN | BMO S&P/TSX Capped Composite Index ETF |
| VUN | Vanguard U S Total Market Index ETF | ZUN | BMO S&P 500 Index ETF |
| XEF | iShares Core MSCI EAFE IMI Index ETF | ZEA | BMO MSCI EAFE Index ETF |
| XEC | iShares Core MSCI Emerging Markets IMI Index ETF | ZEM | BMO MSCI Emerging Markets Index ETF |
And for the American workshop portfolio, here’s my shadow ETF list.
| ETF | Description | Shadow ETF | Description |
|---|---|---|---|
| BND | Vanguard Total Bond Market ETF | AGG | iShares Core U.S. Aggregate Bond ETF |
| VTI | Vanguard Total Stock ETF | ITOT | iShares Core S&P Total U.S. Stock Market ETF |
| VEU | Vanguard FTSE All-World ex-US ETF | IIXUS | Shares Core MSCI Total International Stock ETF |
To see if an ETF would make a suitable shadow for your “main” ETF, simply pull up Google Finance and overlay the two ETF symbol’s price charts on top of each other. If they look like this:
Then they’re sufficiently highly correlated to use as a shadow.
One More Caveat for Americans: Short-Term vs. Long-Term Capital Gains
Oh and one more thing before we go.
For Canadians, a capital gain is a capital gain is a capital gain. But for Americans, the IRS differentiates between short-term capital gains and long-term capital gains. Basically, short-term capital gains are from sales of ETFs that you’ve owned for less than a year, and long-term capital gains are from sales of ETFs that you’ve owned longer than a year, and that’s important because short-term capital losses can only be used to offset short-term capital gains.
Similarly, long-term capital losses can only be used to offset long-term capital gains, so because your portfolio is going to be used for your retirement, you’ll likely be realizing long-term capital gains years down the road. Therefore, make sure any capital losses you harvest now you’ve owned for more than a year so they’d get classified as long-term capital losses. Otherwise, you might harvest the wrong type and then not be able to use it, which would suck.
Peace Out!
OK that’s it for me! Is anyone out there planning to take advantage of the market turmoil to do some sweet sweet tax-loss harvesting? Let’s hear about it in the comments below!
Or…read on to the next article!
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.
Great write up of a potentially complex topic. I would emphasize that in the US capital losses act against your ordinary income first, up to the $3,000 limit. Then they get carried forward into other years.
So this can be done while working, but some of your losses are used against your wages. For example, if you harvest $10,000 of losses but are still working you use $3,000 of this against your annual wages in the current year. So in the next year you have $7,000 left in losses. However, if you are still working you would again take $3,000 against your income. This would leave you $4,000 for the next year, and so on.
While this does at first sound like a strategy for retired people, it may actually work better if you are still employed. Your tax rate now is likely much higher than it will be once you are retired. At a 20% bracket that $3,000 of income deductions is a better deal, than if you are retired and in the 0% to 15% long term capital gains tax bracket.
Happy Easter! We will likely do this with my parents investment account as they are close to 90 and have a high capital gain exposure 🐰🐣
Next time, cover Tax-Gain-Harvesting. I used it for years to raise the cost basis of my AAPL shares.
Be very careful on wash sale. I heard IRS is now beginning to look at the “shadow ETFs” and making sure at least 25% of its holdings (market capwise) are different from the sold one.
Can you clarify this in the Canadian context? This youtube clip from a TD advisor says that if you buy another ETF within 30 days with the same underlying holdings, you would run afoul of the CRA:
https://www.youtube.com/watch?v=0PROLfiGelk
True. Just confirm that the two ETFs don’t follow the identical index and you’re good.
Ps: no such thing as ZUN.
Sorry Wanderer. I think you might have to edit the post a bit on that.
Yes.
Just switching to another ETF that Tracks the same index isn’t qualifying for tax loss harvesting. From different company has nothing to do with it.
If you just choose the ETF that tracks the same index but from different company like Wanderer mentioned, CRA will treats it as a superficial loss.
You should find ‘pretty similar’ ETF that tracks the different index.
Here are some ETF pairs that Justin Bender wrote on his blog.
https://www.canadianportfoliomanagerblog.com/part-4-which-etf-pairs-should-i-use-when-tax-loss-selling/
I would assume that this is harder to do with mutual funds vs ETFs since mutual funds are traded at end of day and therefor you risk a higher price for the buy back the next day?
I’m not so sure about the type of loss only being used to offset a similar type of gain. For example, I’m pretty sure short-term losses can be used to offset long-term gains after first offsetting any short-term gains.
Perfect timing guys. hope you guys are enjoying the isolation in toronto.
I have two questions and appreciate i any you answer in layman terms
Q1>How we would (or brokerage) know the cost base exactly
ex: i have bought the VAB @ 23, 24, 25 or the past few years but i i sell right now @24, how do we know if the purchase price of this ETF whether its 23 or 24 or 25 ?
Q2>I bought the ETF’s mentioned in this workshop but never sold at all. Surprisingly i saw the 2019 T3 (Non Registered) has some incomes that my accountant added to my 2019 tax returns.
Can any one help me understand what these amounts and which ones are really taxable?
a>VAB:
Box#26 – Other income – $184
Box#25 Foreign non-business income – $5.80
Box# 42 Amounts resulting in cost base – $0.12
b>VCN:
Box#26 – Other income – $0.91
Box#49 Actual amount of eligible dividends $743.02
Box#50 Taxable amount of eligible dividends $1,025.37
Box#51 Dividend tax credit for eligible dividends $154.01
Box#25 Foreign non-business income 2.79
Box#34 Foreign non-business income tax paid 0.01
Box#42 Amounts resulting in cost base adjustment 23.83
c>VUN:
Box#25 Foreign non-business income 553.57
Box#34 Foreign non-business income tax paid 88.73
Box#42 Amounts resulting in cost base adjustment 0.42
c>XEC:
Box#25 Foreign non-business income 142.77
Box#34 Foreign non-business income tax paid 22.17
Box#42 Amounts resulting in cost base adjustment 13.26
c>XEF:
Box#21 Capital gains 11.94
Box#25 Foreign non-business income 450.48
Box#34 Foreign non-business income tax paid 38.73
Box#42 Amounts resulting in cost base adjustment 1.77
Q1. At least with Fidelity, when you click on the mutualfund/ETF, there is an option to click on “Purchase History/Lots”. This will tell you the type — short or long — as well as the cost basis for each purchase. With Fidelity, when you sell, you are selling the first ones you bought UNLESS you tell them otherwise. I’m sure Vanguard has a similar button somewhere.
Thanks for the article. I didn’t know about the fact you can only use short-term capital losses for short-term capital gains and long-term for long-term. Good to know since I need to calculate that for some roll-over losses I have had a few years back.
A few caveats to remember. If your SPOUSE buys the security within 30 days before or after your sale–that could create a wash sale situation. If you or your spouse buy the security in a RETIREMENT ACCOUNT like an IRA within 30 days before or after that could constitute a wash sale. Wash sale buys could include simply reinvesting dividends or capitals gains as well. You really have to pay attention with this stuff. But it is worth the effort!
Does it work with Mutual Funds instead of ETF? Could you shadow VTSAX with VTI and vice versa?
Would you do that only if you need to sell?
Another move that could be beneficial is moving stocks into your TFSA during the current (hopefully) temporary dip.
I had stocks that had appreciated a lot in an unregistered account. I should have put them into my TFSA a long time ago once room was available, but it would’ve triggered a pretty sizable capital gain. By moving them while they’re currently under my book value, I’ll have hopefully avoided paying any taxes when the value goes back up.
Only if you sell in your unregistered account into cash first. A transfer in-kind wouldn’t be eligible for a capital loss.
In this case I’m not looking to claim a capital loss, just looking to shelter my investment into a TFSA without paying capital gains.
Thanks for this informative post! I’d heard the term “tax loss harvesting” before, but never knew exactly what it meant. Now, I’m all clear 🙂
Perhaps I am not getting the capital loss harvesting completely. Consider the following scanario.
I bought shares of Bank A for $1000 in 2018.
Now those shares are down to $700. I sell those shares and harvest capital loss of $300.
I buy shares of bank B for $700.
Assume that bank a and B are similar.
Assume that in 2022, these share value of $700 increase to $1200.
I sell shares for $1200, making a capital gain of $500.
Net capital gain in 2020 = 500 -300, i.e. $200.
If don’t do capital loss harvesting, i.e continue to hold original shares and sell those for $1200, my capital gain would be $200.
So, how does capital loss harvesting help an investor?
It’s true. Harvesting a loss likely just creates a larger future gain. However, time value of money. I’d rather take the loss now and the taxable gain later.
Also, in the US, the loss can offset ordinary taxable income up to 3,000/year. This provides tax rate arbitrage since capital gains are usually taxes less than ordinary income.
Very timely article. In the US, short term losses are first paired with short term gains, just as long term losses are paired with long term gains. However, if there are any differences, the net short term is then combined with the net long term. So if you ended up with $1,000 in short term losses and $750 in long term gains, you can still take a $250 loss when filing taxes.
For similar funds for reinvestment, I usually look at a similar but not exact index. In our Schwab account I jump back and forth between a Total US Stock fund with 3700 stocks and a US Broad stock fund with 2500 stocks. Those two indexes track similar but obviously are not exact.
If you purchased a security less than 30 days BEFORE selling (not only 30 days after), it would not be eligible for a capital loss either! Aka Superficial Loss.
Another interesting point to note regarding the disposition (selling) and retention of some portion of the shares, and I’ll just copy any paste from the article (Canadian context) referenced below:
“When Shares are Fully Sold Quickly After Being Purchased
How about when shares and bought, and then fully sold immediately after? Can a capital loss be claimed in this case? As long as all the shares a sold, and you don’t repurchase the shares within the 30-day period following the sale’s settlement date, you can claim a capital loss. Remember that two conditions must apply for the superficial loss rule: shares must be bought within the 61-day period, AND, some shares must still be owned at the end of the period. In the case where all shares are sold (and nothing’s repurchased) the superficial loss rule does not apply as long as you don’t own any shares at the end of the 61-day period.”
Reference: https://www.adjustedcostbase.ca/blog/what-is-the-superficial-loss-rule/
So, you wouldn’t advise to buy and sell to re-balance your portfolio to match your preferred allocation percentages right now?
Others disagree with this article. Two funds tracking the same index are considered identical property and switching them is a superficial loss with tax consequences. Don’t do it !
https://canadiancouchpotato.com/2014/11/03/tax-loss-harvesting-revisited/
“Question – would switching from VUN (TSX.traded) to VTI (NYSE traded) be deemed a superficial loss?
-That’s a great question. Remember, all we have to go on is the CRA’s bulletin of 2001, and that says two index funds tracking the same index are considered identical property. VUN and VTI track the same index, so by that definition they are identical property. “
Our wealth adviser (we inherited him when we inherited the folks’ estate) proposed doing ti a bit differently: first buy an equal number of shares. Then wait 31 days and sell the older shares. The idea apparently is to not have that money sitting in cash while the shares begin to re-appreciate. Of course this assumes you have the assets available to purchase the extra shares in the first place!
I agree with others, the criteria used by the Canada revenue agency for a washsale are broad and could be interpret by one of their employee to bite you in the ass.
When I do tax harvesting, I ensure that the strategy of the fund is different. I usually switch from low volatility to index and back after 31 day. Perhaps I lose a little appreciation, but I avoid to give an ARC employee room for interpretation.
Thanks for the article. I was just opening my Vanguard VTSAX account yesterday and it hit me, “What about the tax loss harvesting I get from my Wealthfront account automatically?” I know the computers will do a much better job of tax loss harvesting than I could ever do manually.
I froze for a few minutes but then I just went ahead and opened the account, trusting that others do the same. So now I have both.
But honestly, I’m still totally confused on whether to keep both or … choose one. I really want to simplify, but not be ignorant to the best option.
I’d love to hear from others who have been in the conundrum and what they chose.
Happy investing!
Quick question: buying a shadow ETF will reduce cost basis. That means you will pay higher capital gain tax in future. How can you save tax using the statege?
Thanks for this interesting article. Tax Loss Harvesing is not the most wonderful way to rise money. Frankly, speaking that’s really hard to cover all those taxes, as budgeting is not such an easy thing. Sometimes you just need to get christmas loans and use those funds towards your dream. The holiday season is really high when it comes to investing, and you could easily take money for your needs.
If you sell: XEC or XEF or XUS at a loss then you also buy XAW within the 30 days. Will it count as tax loss harvesting?
Also, if you just sell a fraction of your holdings in XEC or XEF or XUS will it count tax loss harvesting provided you do not buy them but buy XAW?