ETF Investing Guide: Turning Taxes to Your Advantage

by: David Jackson

You now find yourself sitting on a portfolio of ultra-low-expense, diversified ETFs that cost you hardly anything in fees to buy in an online brokerage account. Your assets are carefully allocated to bond, stock, and real estate investment trust ("REIT") index fund ETFs. If you’re nervous about current valuation levels of any of these assets, you’re keeping the funds allocated to the asset in question in cash in a high-interest-paying money market account linked to your brokerage account. Your ETFs have the lowest possible expenses; represent broad market indices; and are diversified across different industries.

Well, this feels a lot better than your previous holdings: stock in your taxable account (you sold that company routers once and they told you they’d do really well), and The-High-Fee-Under-Performing-Got-4-Stars-Three-Years-Ago-Roller-Coaster-Tech-Fund in your 401k.

All done? Not so fast! You could leave your portfolio for ten years without touching it, and this would probably outperform most other alternatives. But with a minimal amount of management each year, you can further reduce risk and boost your after tax returns. That’s what we’ll discuss now.

John Bogle, the index-fund evangelist who founded mutual fund company Vanguard, has argued that individuals significantly under-performed the market over the last 10 years partly because they jumped in and out of funds at the wrong times. His conclusion is that once you’ve invested in index funds (in our case index ETFs), you should leave them well alone. Buy and Hold. (Or, more realistically for the last three years, “Buy and Shrivel”.) Never sell. Or at least until you retire.

However, while his achievements in promoting low-fee indexing have been truly mind-Bogle-ing, life is actually more interesting than Mr Bogle suggests. Here’s why.

The current US tax rules stipulate that individuals can claim a $3,000 deduction from their current (ordinary) income for net capital losses. In other words, 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. And if you realize a loss larger than $3,000, it carries forward indefinitely. Namely, you can claim $3,000 of losses in each subsequent year until the loss is “used up”. For many people this could be equivalent to an annual tax refund of $1,500 or more. Obviously, the capital loss must be realized in a taxable account, as opposed to a non-taxable account such as an IRA or 401K. (And the IRS stipulates that to claim a tax deduction you must not buy back exactly the same stock or fund within 30 days.)

If this thrilling digression into taxation has caused your eyes to glaze over (guess you’re not an accountant), don’t worry. There is a significant consequence of this tax rule. If, at the end of the year, you sell an index ETF that is trading at a price below where you purchased it, and transfer the funds into a very similar but not identical ETF, you can claim this tax deduction. Yet your portfolio allocation and exposure to the market are unchanged, because you have moved out of one index fund into a very similar one. And the only expense you have incurred to generate that tax deduction is the cost of two trades: one to sell the original ETF, and one to buy the similar-but-not-identical one. That cost breaks down into two parts: the buy-sell spread (the difference between the cost to buy and cost to sell at any given moment), which generally should be small in a heavily traded ETF; and the cost of two online trades, say $20-$40 in an online brokerage account. For that, you generate up to a $1,500 tax rebate in the current year.

There is something remarkable about this that never seems to get mentioned by financial writers. (Wonder why? You mean tax breaks due to investment losses don’t make great stories?) Realizing net tax losses at the end of each year is the only sure way I know to consistently beat the market over time. If the market is down, you sell all your index funds that are trading below where you bought them and move the cash into broadly equivalent funds. That means you beat the market by about $1,500 (a $3,000 tax deduction from your current ordinary income). If the market is up, you do nothing and your performance equals that of the market. So in down years you beat the market, and in up years you match the market. You might even find that if you have carried-forward losses, you get multi-year tax deductions, which means you beat the market in up years too.

When you compound the value of the tax rebates, your long run performance should be significantly better than if you simply buy and hold the index ETFs in your portfolio. You gain in two ways. By investing the tax rebate now, you effectively boost the amount of capital you have to invest, and you get to keep most of the profits (assuming the market goes up) on that extra capital. Next, the US tax system distinguishes between short-term and long-term capital gains. Any net tax loss you realize counts against current ordinary income (taxed at your current marginal tax rate) up to $3,000; yet when you re-invest the value of the rebate, you can generate long term gains on that money if you leave it in place for long enough. Effectively, you are receiving a reduction of the taxes you pay now at your highest tax rate, in return for paying taxes later at a lower (long-term-gains) rate when you eventually sell your appreciated ETF portfolio.

Tax-loss selling is not new. What is new is the ease of tax-loss selling with ETFs. Before the proliferation of ETFs over the last few years, your portfolio would be in index mutual funds. That would present two serious obstacles to tax-loss selling. First, most mutual fund statements do not allow you to identify and trade individual tax lots. Imagine you purchased 1,000 shares of an S&P 500 index fund at $20 a share in 1992. You then purchase another 1,000 shares in 2003 at $80 per share. At the end of this year, the fund shares are at $70 per share. You want to sell the lot you purchased at $80 a share to realize the tax loss. But the fund company tells you only that you own 2,000 shares at an average price of $50 per share, and gives you no way to sell only the 1,000 shares you purchased at $80 per share. You can’t realize your tax loss. Second, even if you could identify and trade individual tax lots, moving to similar but not identical index funds may mean moving assets between fund companies, which is a time consuming burden. This is particularly likely given that the cheapest index mutual funds do not participate in the “mutual fund supermarkets” offered by brokerages like Schwab, since the fees charged by the supermarkets to mutual funds often exceed the total annual expenses of the lowest cost index funds.

With ETFs in an online brokerage account, tax-loss selling is easy and fast. Good online brokerages track tax lots of each block of ETFs as you purchase them, and even show you summaries of unrealized losses so you know what to sell at the end of each tax year. And moving between “fund families” is easy with ETFs, since they are all traded like stocks. All you need to know is the ticker symbol of the fund you’re selling and the fund you’re buying. Also, the number of ETFs has exploded in the last two years, and that means that you can easily find very similar (but not identical) ETFs to transfer into.

The table below lists some of the ETFs in the core portfolio presented in Part 3, and suggests alternative (similar, but not identical) index ETFs to transfer into for tax-loss selling. The S&P 500 and the Russell 1000, for example, have very similar performance, despite the fact that the Russell index has twice as many stocks as the S&P 500. (The reason is that the largest stocks dominate the index, and the S&P 500 basically covers the largest stocks.)

ETF Alternatives for Tax-Loss Selling

Core Holding Fund Name Similar ETF For Tax-Loss Selling Fund Name
(NYSEARCA:IVV) iShares S&P 500 Index Fund (NYSEARCA:VTI) Vanguard Total Stock Market VIPERs
(NYSEARCA:IWM) iShares Russell 2000 Index ETF (NYSEARCA:IJR) S&P Small-Cap 600 Index Fund
(NYSEARCA:RWR) streetTRACKS Wilshire REIT Index Fund (NYSEARCA:ICF) iShares Cohen & Steers Realty Majors Index
(NYSEARCA:AGG) iShares Lehman Aggregate Bond Fund (NYSEARCA:BND) Vanguard Total Bond Market ETF

Bond index ETFs are relatively new, and the lack of available choice limits options for tax loss selling. (ETF Advisors withdrew their bond ETFs from the market due to lack of interest.) However, that should change with time. Vanguard and Fidelity recently released a slew of equity index ETFs, and with time the choice of bond ETFs should widen.

I mentioned that you should think about tax-loss selling near the end of the year. Well, thatís what most people do. But you can switch ETFs to realize capital losses at any point of the year. If the market takes a dive for some reason, you can ìbankî your capital loss by switching ETFs immediately. And if it continues to dive, after 31 days you can switch again - back to the original ETFs you held. In fact, if it makes you happy, you can think about taxes throughout the year.

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