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I’VE BEEN WAITING since late last year for a stock market correction. No, I’m not sitting on a pile of cash and looking to time the market. Instead, I’m simply hoping to trim my tax bill.
Last October, I sold the recently vested shares of my company stock and used the proceeds to buy Vanguard Total Stock Market ETF (symbol: VTI). This sell-high-buy-high exchange was meant for diversification, but I also hoped that the market would drop later. I could then harvest tax losses by temporarily replacing the Vanguard fund with a combination of Russell 1000 and Russell 2000 ETFs. Given the prospect of an interest rate hike to counter rising inflation, a market correction was a distinct possibility.
The market seemed to move in my favor by November’s end. My Vanguard ETF dropped below my purchase price, but the extent of the unrealized loss wasn’t worth the effort of tax-loss harvesting. I waited for a bigger drop, but a market rally wiped out my unrealized loss.
My hopes were renewed during the fourth weekend of January, as I glanced through Barron’s. My Vanguard ETF shares had dropped more than 6% the week before. Another 3% drop would be enough for some meaningful tax-loss harvesting. I planned to keep an eye on the market on Monday.
I logged onto my brokerage account on the morning of the 24th and was pleased to see a further decline, but I didn’t pull the trigger. The rapid price swings made me nervous. What if the market rose substantially between selling my Vanguard Total Market shares and buying the replacement funds? Anything’s possible in a volatile market. I decided to wait another week, hoping the market would settle down.
Instead, the market pulled off a weekly gain and I missed the boat. For now, I’m keeping my fingers crossed, hoping the next boat will come along soon.
Mr. Saha is market timing. What is his past record of success or failure in market timing?
Thank you for your comment, ishabaka.
I think by market timing, you are referring to investment strategy that relies on predicting future price movement of the market. I’m doing something different. What I’m hoping to execute is merely a tax-optimization strategy – a plain-vanilla replacement operation that has no material change in my investments or asset allocation.
For this to work, I need to wait for the market to drop. If it doesn’t, there won’t be any opportunity to harvest tax losses. Unlike market-timing in the traditional sense, my action or inaction won’t change my pretax return or risk exposure of my investment portfolio. All it’d do is to defer my tax liability from present date to a future date when my marginal tax rate is expected to drop.
Hope this clarifies. Thanks again for your note and please wish me luck ;).
Sanjib is most certainly not market timing. He simply wants to be able to take tax losses.
Sorry, I don’t get it. Selling VTI and buying a Russell ETF looks like a reallocation of your equity assets. You didn’t want to buy the Russell ETF initially because you thought it was too high and wanted to wait until it went down? It looks very much like market timing.
Thanks for asking, Carl. As Jonathan explains, there is no market bet involved here. You can think of it as the reverse of the “tax-gain harvesting” strategy (a tax strategy to realize capital gains in a year when marginal tax rate is very low)
If the VTI shares go up and I want to realize tax-gain, I’d simply sell the VTI and immediately buy it back at hopefully the same price. Doing so wouldn’t change my market exposure at all (since I was out of the market only for a minute or so). However, the newly bought shares will have a higher cost-basis (today’s price), and hence the future tax liability of selling those will be low. I’d be paying the taxes on the realized gain this year.
The tax-loss harvesting is just the opposite of the above. The only catch is, due to the wash sale rule which applies only for tax-loss and not for tax-gain, I can’t buy VTI right-away. Hence, I have to buy something that’s almost identical to VTI. In this case, proportional combination of the large-cap and small/mid-cap Russel ETFs is a very close approximation of VTI.
When you take tax losses, you often sell one investment and then buy another investment (or investments) that’ll give you the same market exposure. For Sanjib, if he’d sold Vanguard Total Market and bought the two Russell ETFs (1000 plus 2000, which together give you something similar to the broad market), he wouldn’t be making a market bet. Instead, he would have been realizing a tax loss while explicitly not making a market bet — the very opposite of market timing. This is common practice. After a month, Sanjib could have reversed course and repurchased Vanguard Total Market without violating the IRS’s wash-sale rule.
I appreciate this article Sanjib. As we have a substantial amount in taxable accounts with embedded capital gains, I’ve been thinking recently that I should be more thoughtful about tax loss harvesting, much as you describe.
Have you (or anyone else) also considered replacing tax dragging holdings with a tax managed fund?
Thanks, Michael1. I haven’t used tax managed fund.
Fear not Sanjib. I’d wager the “wild rumpus” is just beginning.
🙂 Thanks, David. Can’t say I’m super-excited about the super-bubble.