Don’t worry, I haven’t turned into some financial “advisor”. I was researching ETFs for my 401k roll-over, and came across this article from RadicalGuides: Turning Taxes to Your Advantage. As you know, I’m a index fund (or ETF I guess) guy. I think it is really hard for an mutual fund with active management to beat the market indices over time, and is really hard to pick ahead of time which ones will do so. So is the writer of this article, but he/she points out a possible new way of using ETFs to make tax-loss selling legal and profitable. Sound confusing? It did to me too, I ended up making up a simple example to wrap my head around it. I’m not 100% sure it is right, please let me know if I am wrong!
The main idea is to take advantage of the fact that the IRS lets you claim a deduction for investment losses against your ordinary income. From the article, this means “if you lose $3,000 on an investment, and you realize that capital loss by selling the stock or fund that incurred the loss without realizing any capital gains in the same year, you can claim a $3,000 deduction on your income tax return.” So you won’t have to pay income tax on $3,000 of your income that you would’ve had to pay otherwise.
On the flip side, if you make money on an investment and you hold it for longer than a year, you only have to pay long-term capital gains tax, which is only 20% for people in a tax bracket greater than 15%. Please see the original article for details.
So here’s my example:
Scenario #1: You are in the 33% tax bracket. Say this year you bought $10,000 of IVV, an ETF that tracks the S&P 500. In 2006 it drops to $9,000, and in 2007 it rebounds to $11,000 and you sell. You’d have a long-term gain of $1,000 from your original $10k, so you pay 20% in taxes ($200), and end up with $10,800 in your pocket. A $800 gain.
Scenario #2: Again, 33% tax bracket. You buy $10,000 of IVV, and in a year (2006) you sell at $9,000, and the very same day you buy IWB, an ETF that tracks the Russell 1000 Index, but is very similar (but not identical) to the S&P 500. Since it tracks very closely, your $9,000 of IWB in 2006 will also rise back to $11,000 in 2007. After a year and a day, you sell your IWB for $11,000.
Now in 2006, you had a capital loss of $1,000 from your IVV. So you deduct $1,000 from your ordinary income taxed at 33% and save $330 in taxes. That’s $330 in your pocket. Then, in 2007 you sell your IWB, and realize a long term capital gain of $2,000. You pay your 20% tax ($400) and you end up with $10,600. Add in your $330 from the last year, and you end up with $10,930. A $930 gain. You just “beat the market”!
Note that you must do this with similar, but not “substantially identical” investments. For example, you can’t buy IVV back again right after selling it and try this. That would be called a ‘wash sale’ by the IRS. More explanation in this Street.com article: When Exchange-Traded Fund Sales Wash, Does the IRS Supply Towels?.
Now, I don’t think I did a very good job explaining this, I was trying to make it all very concise. But the RadicalGuides article is pretty good. I recommend read it first, then going through my two scenarios. As always, comments welcome!
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I believe your example is right on. I use ETF’s and a portfolio of about 13 ETF’s. I got it from William Bernstein and his Efficient Frontier ideas. His books, “Four Pillars of Investing” and “Origins of Wealth” are great reads. The first disucussing investing and beating the market, the second providing an historical account of “wealth”.
Bernstein can be found at http://efficientfrontier.com/
Here’s another link specfically discussing Bernstein, ETF’s, and tax efficiency: http://www.techuncovered.com/qabernstein.html
-Wes
Thanks, I’ve read Four Pillars of Investing (Review) but not Origins of Wealth. Sounds intriguing.
I’ve also neglected trading costs and the bid-ask spread in computing the scenarios, so I think the 2nd scenario would be reduced by about $30.
Well, you addressed every concern I had.
Like you said, the investment losses deduction from your ordinary income can be deferred some years in the future… but it can also be applied to a previous tax filing! Keep in mind I learned that from TurboTax and I can’t imagine how confusing filing that sort of deduction would be.
Excellent tactic. I wonder if it will work if you sell IVV and buy SPY(S&P 500 tracking) instead of IWB. IVV and SPY are virtually identical.
anon – That’s where you get into a grey area. Read the TheStreet.com article for more details, but that could be considered by the IRS to be a wash sale.
The only problem I see with this strategy is when the market goes up first and then down. For example, you buy an $10K of ETF in Year 1. In year 2 it goes up to $11K, in year 3 it goes back down to $10K. There isn’t a way to recognize the “loss” from year 2 to 3. If you do regular investing, i.e. you bought another $11K in Y2 that went down to $10K in Y3, you could recognize it on the second investment, but not the first. Seems like it only works if the loss is in the first year? You could sell EVERY year, but then you lose the benefit of defering your long-term capital gains. Am I missing anything here?
Yes, that is a very good point. This only works for down years. If years that the index you are tracking goes up, you do not sell and you simply match the performance of the market. However, in the long run, this still appears to give you a way of beating the market.
I’ve been using this strategy with my clients for years, so it’s really nothing new although the proliferation of index ETFs has made it simpler.
Since the maximum long-term capital gains rate is 15%, not 20% as you stated, some of your calculations are wrong.
See, a professional financial advisor really can prevent you from making mistakes…
Thanks for the correction. I’ll leave it be for now, it doesn’t change things too much. As for an advisor, I think a $30 Quicken program could have corrected me about the tax rate table =)
But I’m not against all financial advisors. Just those that are fresh college graduates who take a 8-week course and are given a ‘finanical advisor’ badge.
Jonathan –
I think you have found an interesting tax strategy. The key will be finding very highly correlated indexes to swap in and out of when you need to sell to gain the benefit of tax losses.
However, I’m not sure that just being tax efficient will have you beating the market. If you want to beat the market long-term you need to invest with a margin of safety.
For index funds, you can obtain a margin of safety by timing your purchases in various indexes to avoid buying into them when the markets are overvalued. I recommend taking a look at Ben Stein and Phil DeMuth’s work on Yes, You Can Time the Market.
I also recommend that you only resort to this tax trick if you have already maxed out your Roth IRA, Coverdell ESA, and 401k or other tax advantaged accounts first. It is better to have tax free earnings than to be able to write off tax losses.
I believe that I read something about this before, somewhere. I think it said that there is a 30 day buyback time you have to wait in order to write the loss off on your taxes. I’m not sure if this is correct or if it is, if the wait period is 30 days. Check it out before you try it though. Don’t want the IRS knocking on you’re door.
If you use an index as the benchmark, you still won’t beat the market, because the benchmark ignores all commissions and taxes. You’ll just be closer to the market. =)