Selling at the bottom offers tax advantages
I’m waiting for one more really bad day in the stock market to sell all my shares in an index mutual fund.
Am I insane for wanting to sell at the bottom of the market? Hardly. My two-step plan allows me to trigger valuable tax losses while lowering my investment management costs.
You might want to consider doing the same if you have shares in a stock index fund, as long as you bought them in recent years -- so that the market’s slide in the last year has put the investment in the red.
The trick to it is this: You sell a fund to trigger capital losses, then immediately buy one or more funds that mimic the portfolio you just unloaded.
Let’s say you bought a $90,000 stake in Vanguard Total Stock Market Index mutual fund at the end of 2007. Thanks to plunging stock prices, your $90,000 stake is now worth about $53,000, giving you a $37,000 unrealized loss.
If you sell now, that loss becomes tax-deductible, although the rules for deducting it are a bit complicated. If you’re fortunate enough to sell some other investments at a profit this year, you can use the entire $37,000 loss to offset your 2008 capital gains. That would save you as much as $5,550 in federal income tax when you file your return in April (based on a 15% capital gains tax rate) and would probably lower your state income tax bill as well.
If you don’t have any gains to offset, you can use up to $3,000 of your capital loss to offset ordinary income each year. If your combined federal and state tax bracket is 30%, this would save you $900 a year for 12 years, plus $300 in the 13th year, for a total savings of $11,000.
That’s the first step. The second step is to immediately reinvest your money in a very similar portfolio to ensure that you’re not falling into the trap of selling a holding that has plunged in value in exchange for securities that have held up better.
You can’t invest in Total Stock Market Index again because tax rules bar you from claiming a capital loss on the sale of an investment if you turn around and buy “substantially identical” shares within 30 days.
Instead, you can seek to replicate the portfolio you just sold. Because Total Stock Market Index is designed to track an index of all U.S.-traded stocks, you can mimic it by putting 90% of your proceeds in Vanguard Large-Cap ETF and 10% in Vanguard Mid-Cap ETF.
Here’s how the old and new portfolios compare:
Total Stock Market Index holds shares in more than 3,000 companies with an average market capitalization (stock price times number of shares outstanding) of $72 billion.
Vanguard Large-Cap ETF, which tracks the MSCI US Prime Market 750 index, holds 744 stocks with an average market cap of $82 billion. Vanguard Mid-Cap ETF, which tracks the MSCI US Mid Cap 450 index, owns 444 stocks with an average market cap of $5.5 billion.
That means your new composite portfolio has 1,188 stocks with an average market cap of $74 billion -- not exactly the same as your old portfolio but reasonably close. Both portfolios are down 41% year to date.
And your recurring investment costs are lower too. Vanguard Total Stock Market Index charges annual expenses of 0.15% of assets (0.07% if you have more than $100,000 invested in the fund).
Vanguard Large-Cap ETF charges 0.07% regardless of the size of your holding, while Vanguard Mid-Cap ETF charges 0.13%.
Because the stake you’re selling in Total Stock Market Index is less than $100,000, you’ll be trimming your annual expenses from 0.15% to a weighted average of 0.08%.
(Of course, if your stake is more than $100,000, your expenses will rise from 0.07% to 0.08%.)
One down side is that you have to pay a broker’s commission to buy or sell shares in an ETF. There’s no transaction fee with Vanguard’s traditional mutual funds.
Another hitch: Those tax savings you get by realizing a big capital loss are actually only temporary, assuming the stock market eventually recovers. Because you are buying your new funds at depressed prices, your eventual capital gain once you sell them -- say, when you’re retired -- will be bigger than it otherwise would have been.
So think of the tax savings as a very long-term, interest-free loan -- which is nothing to sneeze at.
There’s one more option to consider: Instead of buying two ETFs, you could buy one: Vanguard Total Stock Market ETF, which owns exactly the same portfolio as the traditional mutual fund you’re selling.
Doing that would save you a bit more on expenses. Vanguard Total Stock Market ETF charges 0.07% of assets each year, compared with 0.08% for the portfolio containing Large-Cap ETF and Mid-Cap ETF.
Plus, because the underlying stocks in your portfolio wouldn’t be changing, you wouldn’t have to worry that you’re making a bad investment move.
But wouldn’t you be violating the IRS’s 30-day rule? Good question -- and the answer isn’t all that clear.
To claim a loss for tax purposes, you would have to argue that Vanguard Total Stock Market Index fund and Vanguard Total Market ETF are not “substantially identical” even though their portfolios definitely are.
You might have a good case: The traditional mutual fund can be traded only once a day, at the fund’s net asset value per share, calculated after the stock market has closed. The ETF can be traded on the open market at any time of day at a price set by the market.
Plus the ETF has lower annual expenses if you have less than $100,000 invested.
Still, the IRS might challenge your attempt to deduct the capital loss, said Philip J. Holthouse, partner in the Santa Monica tax law and accounting firm of Holthouse, Carlin & Van Trigt.
“There isn’t a lot of guidance on this,” said Holthouse. “It comes down to how someone is going to define ‘substantially identical.’ You could certainly argue that they were different.
“But if you wanted to be entirely safe -- or take the most conservative position -- you would buy an ETF that was based on a different index. In that case, there’s no way that you would lose.”
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