Outsmart Uncle Sam This Tax Season

by Dan Wiener | November 12, 2008 11:24 am

Making changes to your investment
portfolio simply for tax purposes is
never a cut-and-dried decision, and I’ve
never been one to suggest you should
let the tax tail wag the portfolio dog.

That being said, it would be a shame
to end a year that will give us portfolio
losses—barring some miracle—and
also end up paying taxes on funds’
year-end distributions without trying to
at least minimize the impact.

Vanguard recently said that it doesn’t
expect to make big, or many, capital
gains distributions this year, but you
never know, and it’s always good to be
prepared for the unknown.
To that end, here are a few things to
think about if you think you want to realize
some losses in your portfolios now. (See also: "5 Vanguard Funds to Sell Now[1].")

First, of course, don’t go taking
losses in a fund that you’ll have trouble
buying back into. Remember that,
because of Vanguard’s limits on trading
and investments into closed funds[2], selling
may not be to your advantage if you
can’t put the bulk of your money back
into the fund.

For instance, non-Flagship
shareholders are limited in their
ability to add to funds such as Capital
Opportunity (VHCOX[3]) and PRIMECAP (VPMCX[4]). You
wouldn’t want to sell off $50,000 worth
of Capital Opportunity shares and then
be limited to adding back just half that
amount.

Second, don’t fall prey to the washsale
rules. In short, if you sell shares at
a loss within a 30-day window on either
side of a purchase of shares in that same
fund (whether through reinvestment or
outright purchase—it doesn’t matter),
you will not be allowed to realize that
loss for tax purposes[5]. The wash-sale
rule’s intent is to prevent you from
selling a fund or stock, say, for a loss
on Monday and then repurchasing it on Tuesday.

The wash-sale period is actually
a 61-day window which includes
the day you sold your fund (or stock
or bond) at a loss plus the 30 calendar
days on either side of it.
The rule concerning a purchase
within 30 days prior to the sale has to
do with "replacement shares." If you
have purchased identical "replacement
shares" within the 30-day window prior
to the sale, this would disallow taking
the loss.

For instance, if you own
100 shares of Fund XYZ at a cost of
$50 and you buy another 100 shares
on November 1 at $40, then sell 100
shares on November 3 at $41. You
try to take the loss on the $50 shares
but you can’t because you bought 100
identical shares just two days before.

That’s a no-no…

Investors who reinvest monthly
distributions[6] from their fixed-income
funds are particularly susceptible to
running afoul of the wash-sale rule
since they may buy shares every month.

And if you think you’ll be able to take a loss on some fund shares after
a dividend distribution and reinvestment,
when the share price has fallen,
think again. To do so before the end of
the year will certainly put you inside
the dreaded 30-day window. (See also: "7 Mutual Fund Mistakes to Avoid[7].")

Also, if
you’ve already reinvested your income
fund’s November income distribution,
you won’t be able to book a loss on a
sale in December.
That said, the loss that is disallowed is
only on shares equal to the number purchased
inside the 30-day window. So, if
you’re selling 2,000 shares to take a loss
and you happened to reinvest a distribution
and got 5 shares in the transaction,
you’ll still be able to deduct the loss on
1,995 shares.

The issue of not buying something
again within 30 days of realizing a loss leads directly to my next bit of advice,
and something I’ve told investors to
do for years. Rather than automatically
reinvesting, have Vanguard[8] send your
distributions to your money market
fund instead.

That’s right: Don’t reinvest,
particularly if you’re doing some
tax-loss selling within the 30-day window
prior to a fund’s distribution date.
This is particularly important if
you’re selling only a portion of your
shares in a fund to take a loss, and
doing so close to a distribution date.

For
instance, you’ve bought shares every
month and now want to sell only those
that are underwater. The problem is that
you will still receive a distribution on
your remaining shares, and if you reinvest
your distribution (within 30 days of
taking the loss), you’ll run afoul of the
aforementioned wash-sale rule.

Fund investors have a way around
the wash-sale rule, of course. We can
sell a fund to take a loss and buy
a similar investment, which we then
hold for 30 days. After that time, we can sell it and repurchase the original,
preferred fund if we want. The funds
can’t be exactly alike, however, such
as exchanging one S&P 500 index fund[9] for another (though exchanging for an
ETF might work), or selling a fund’s
Admiral shares and buying the Investor
shares.

The IRS frowns on these shenanigans,
though I’m not aware of its
having been tested in tax court. But
better to be safe than sorry.

One last thought. If you do want to
make some allocation changes or do
some rebalancing in your portfolio,
take your losses in this calendar year,
but wait until January 2, 2009, to take
gains. That way, you can use your
losses on your 2008 tax return, but you
won’t owe the IRS taxes on your gains
until you file in 2010.

If you’re looking for the inside help that gives you special advantages over other investors at Vanguard, click here to accept a risk-free trial[10] to The Independent Adviser for Vanguard Investors. Each month, in every issue, Dan will show you all your options and tell you what Vanguard can’t—and in some cases won’t–tell you. You’ll get independent and unbiased in-depth information on Vanguard funds, including the best funds to buy, alternates for closed funds, advance warning of funds likely to close, changes in management and much more. He’s been doing it for over 17 years for his subscribers, and his track record of providing a 144% advantage is proven and irrefutable. Join risk-free today[11]!

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