[As with anything tax-related, see my disclaimers.]
As with anything investment-related, see my disclaimers. This post deserves an additional disclaimer. Investing involves risk. I no way do I recommend any course of action. Don't trust random idiots like me on the internet for investing advice. Or for anything else, for that matter.
A couple of years ago, I closed my Wealthfront account. After closing my account, I set out to DIY a tax loss harvesting system, modeled after Wealthfront. I’m tempted to call it my level 5 asset allocation strategy.
Building my own tax loss harvesting system has a few advantages, including:
- Avoid Wealthfront’s .25% management fee
- Avoid capital gains by donating appreciated shares instead of cash
- A minor endorphin rush from pushing the buy/sell buttons myself. Yep, I’m a little different
Disadvantages, many of which fall in the “likely overly complicated” category, include:
- Keeping track of my target allocations, rebalancing as appropriate
- Preventing wash sales
- Detecting lots that can be harvested for a loss
- Not being able to trade as efficiently as Wealthfront’s “robot”
Who Wants To Lose Money?
So first off, no one likes to lose money. But, this is really not a loss. Why? Because after selling an ETF at a loss, I immediately buy another ETF that is highly correlated, but different. Why? To avoid the IRS wash sale rules. Buying a correlated asset means that I remain in the market even after taking a loss, and in theory when the original asset recovers in price, the correlated asset goes up as well. It would only be a permanent loss if I was out of the market and missed out on the recovery.
There are several ways to profit from a tax loss. First, a loss can reduce up to $3,000 of regular W2 income. I’m in the 22% tax bracket, so that’s worth $660 in federal taxes, and another $173 in Virginia state taxes.
If that was the only benefit it wouldn’t be worth it. Why? Because whenever I go to sell it, I’ll possibly run into a capital gains tax of 15% (2020 numbers), which means that $660 of federal tax gets reduced to $450. However, since I regularly give to charity (not virtual signally, I promise!), I gift with appreciated shares that I’ve held for longer than one year instead of cash. Doing this means I avoid paying capital gains taxes on the appreciation. I can use the cash I would have contributed to buy more shares, effectively getting a reset on my cost basis to a higher value.
What Am I Trading?
I mostly adopted the same index ETFs that Wealthfront uses. Just like Wealthfront, I have primary, secondary and tertiary ETFs, and in one case I have a quaternary set of ETFs. Here’s a table, including my target allocations:
|Sector||Allocation||First ETF||Second ETF||Third ETF||Fourth ETF|
|US Large Cap||34%||VTI||ITOT||SCHB||VOO|
|US Small Cap||9%||VXF|
For example, pretend that I have 10 shares of VTI. The price of VTI drops and I harvest a loss by selling the shares. I immediately turn around and buy shares of ITOT with the proceeds. After 31 days, if ITOT falls more, I can sell those shares and immediately buy back into VTI. If instead, ITOT falls before 31 days are up, I can still sell ITOT, but instead of buying VTI and hitting the wash sale rules, I instead buy shares of SCHB. It’s possible to exhaust the hierarchy, in which case I can’t harvest additional loss until the first 31 days expires. Oh well. You can’t win them all
You’ll notice that the US Large Cap and US Small Cap share the primary, secondary and tertiary. That’s because my mix mostly aligns with the internal allocation of those ETFs between large cap and the rest. But if I exhaust my options, I can buy VOO and VXF in equal measure and maintain the correlation. Rarely happens, but it did happen in March.
I do all my trading through my Vanguard brokerage account where ETFs can be traded with zero commission. This system could be done anywhere there is zero-commission ETF trading.
Looking for Losses
My tracking system is a Google Sheet that I’ve built using the GOOGLEFINANCE function to automatically pull the latest share prices. I use the sheet to track both my tax advantaged and taxable assets, and it warns me whenever I risk a wash sale by selling an asset at a loss in my taxable account.
In addition to tracking my gains and losses, my sheet calculates whether my allocation in a particular asset needs to be changed. When do I rebalance? After reading this article by Michael Kitces, I settled on rebalancing an asset whenever it varied more than 20% from its target allocation.
Here’s my current allocations percentages. It looks like it’s time to rebalance my natural resource allocation. My small cap is also getting close to needing an adjustment.
How often do I check for losses or when a rebalance is needed? Again, after reading Michael Kitces’s article, I settled on checking every week or two. A quick glance at my spreadsheet will tell me if anything is ripe for harvesting, as well as whether a wash sale will happen. It only takes a couple of minutes a week, tops.
October 2020 Update
Nearly 900 words in and I’m finally getting to the point of this article: to give an update on my tax loss harvesting scheme for 2020.
The market has fluctuated wildly this year, mostly due to the pandemic. But even with the wild moves, if I had done nothing, just sitting on the assets that I had at the beginning of the year, to date my total portfolio would have decreased only by -.78%. True, the market dived in early March, but it’s mostly recovered. Far from the best year to invest, but also far from the worst.
On the other hand, my tax loss harvesting has been a wild success. I had twelve different times that I sold shares to capture losses, all of which happened in the first four months of 2020. Currently, my account balance is 1% bigger than the Do Nothing scenario, if we account for the harvested loss. But despite having mostly the same balance at the end, I also scored nearly $6,000 in losses that can be used to offset my gains from selling covered calls and regular W2 income.
Here’s a table breaking it down by month by month:
|Month||Do Nothing Gain/Loss||Harvest Gain/Loss||Harvested Losses|
And in graph form:
As a side note, 2020 has been another successful year to front load my 401(k), especially with several large buys right during the market dip in March. To date, my 401(k) balance has appreciated 6.83%, most of that attributable to front-loading.
2020 isn’t over. There will probably be additional opportunities to harvest some loss by the hend of the year, depending on the election outcome. We’ll see.
Do you do any tax loss harvesting? I’d love to hear about it in the comments.