On 8/10/2018, time stood still in the mutual fund industry. Just kidding, but Fidelity did announce a one-two punch that should be examined and carefully considered by the personal finance community.
First, they announced some interesting reductions and simplifications of their fees and pricing structure:
None of these fees are really deal breakers, but are primarily frustrations of the industry nickel and diming their customers. It’s nice to see them taken away. The big change in the table above is on the first line, “Minimum Initial Investment – $0”. This is a huge win for all investors, because it essentially opened access for all investors at the cheapest level of investing (the institutional class shares). There is no more transferring from investor class, to premium class, etc. This news alone is enough to make us jump for joy, but then they did the unthinkable:
Fidelity announced not one but TWO completely zero-fee index funds: A Total US Stock Market fund, and a Global ex-US Stock Market fund… This is huge.
Now, this post is not an advertisement for Fidelity, but this is seriously good news for us finance geeks for 2 reasons. First, fees across the board are dropping like flies and and make this an incredibly exciting time to be investing. And two, because this makes the process of tax-loss harvesting at Fidelity even more attractive and easier than ever to implement.
And that is the main topic for this post. I will be sure to come back and really analyze these two new funds for you later, but I will cover the essentials as we continue. So with that said, let’s begin!
What Is Tax-Loss Harvesting?
Tax loss harvesting is one of the superpowers of the FIRE community. It is the practice of selling a security that experienced a loss in order to reduce your future capital gains and income.
Yes, that’s right – it’s one of the weird cases where buying high and selling low actually makes sense in the markets. But don’t worry, the goal is not to sell low and go away. When you properly tax loss harvest, you immediately purchase a similar stock or fund in order to maintain your desired asset allocation.
Let’s go through a simple example to make it clear:
You buy the S&P500 Index fund for $100 on January 1. Over the course of the next few months, the value of the fund drops to $80, for a $20 loss. You, being a savvy investor, decide to “harvest” the loss by selling the entire position (harvesting $20), and immediately purchasing $80 of the Total Stock Market Index Fund.
By doing this, we have captured $20 of capital losses, which can be applied to any future gains we have when we eventually sell our appreciated stock. But what’s even greater is that you can offset your taxable income for that year (and future years) by up to $3,000 of your harvested losses. So if you had a taxable income of $500 that year, you could apply your $20 of losses to it to reduce your taxable income to only $480.
It is important to note that there are limits on tax-loss harvesting. They are captured in the “wash sale” rule, which states that when an individual sells or trades a security at a loss and, within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. When a wash sale occurs, you lose the benefit of the reduced cost basis, and essentially, the entire exercise is a wash 🙂 To visualize this:
The wash sale rule essentially creates a 61 day moat around the day you sell the stock at a loss. This is bad news as we want to maintain our asset allocation throughout the entire time. This is why we substitute a very similar stock in place of the one we just sold. For example, if we sell the SP500, replace it with the total US index fund, or something that has a high correlation. This maintains your desired exposure continuously:
Once you pass the 30 day hold period after selling stock 1, you get to decide if you want to hold onto stock 2, or sell it and go back to stock 1. In general, I would never sell the stock if it has appreciated during that time period (the whole point of this is to reduce taxes!), but if the stock is flat or also negative, you may decide to harvest in the opposite direction. We will go through all this click by click later in the post.
Why Should I Tax Loss Harvest?
While this may seem like a lot of effort for minimal payout, it’s important to examine the real benefits here.
First, the tax savings can be significant. In betterment’s white paper, they estimate an additional .77% annual returns through tax loss harvesting.
Obviously, everyone’s tax situation will be different, but if you are in the 30%+ tax bracket, you can think about it as every $3 of taxable income you remove through harvesting, you pay $1 less dollars in taxes (all else equal!).
And when you take those savings every year and pump them back into your investments, and rinse and repeat for 5, 10, 15 years of investing, the results can be extremely beneficial!
Do I Ever Have To Pay It Back?
Unfortunately, yes, but there’s a huge catch here for us. When we are in the higher income earning years (while accumulating our FI money), we are most likely in the highest tax bracket of our lives. We can never truly know the future of the tax code but I think it’s a solid assumption to make.
And since you are reading a personal finance blog, I am assuming that you are anticipating to have a fairly inexpensive “retirement,” which would bring you into a lower tax bracket.
And if you happen to control your income to be in the 12% tax bracket (under $38,700 for single, $77,400 for filing jointly), you get an additional perk of not having to pay ANY capital gains on the sale of your investments!
2018 Long Term Capital Gains Rates by Income Level
Just take that in for a moment… you can engineer a situation where you reap the maximum benefit while working by offsetting your taxable income, and never have to pay it back through income management in early retirement! This is a true hack that is completely worth implementing!
How Can I Tax Loss Harvest?
I hope this brief explanation has gotten you a bit excited to start harvesting those sweet, sweet losses.
There are 2 main ways to implement tax loss harvesting: The automated way, and the DIY way.
If you’re a totally hands-off kind of person, I totally understand, and roboa-dvisors like Betterment and Wealthfront have algorithms that can implement the harvesting for you.
But it’s important to understand the price you are paying for that privilege. Betterment currently charges a .25% management fee ON TOP of the expense ratios of the underlying funds in the portfolio. So assuming you’re aggressive like me and have a 100% stock allocation, Betterment’s portfolio will average somewhere around a .12% expense ratio – which is a pretty low expense ratio for a diversified portfolio. But tack on that management fee, and you are quickly looking at a .37% per year fee. Again, not bad, but we can do better.
In fact, much better. With this news from Fidelity, we can construct a portfolio that is perfect for tax loss harvesting with funds with expense ratios ranging from 0.00% to 0.06%… assuming an equal weight of each fund, it comes out to an overall portfolio expense of a mere 0.019% expense ratio! That is a 95% reduction from the .37% Betterment cost. And as you will see below, it takes only minutes per month to implement, and can actually be a psychological win.
I have found that by being able to capitalize on market corrections, it strengthens my resolve not to sell, because I am able to take SOME action that I know is helpful for me long term when the markets get volatile.
Tax Loss Harvesting With Fidelity, Step By Step
This guide will obviously showcase Fidelity, but the steps can be followed on any brokerage, with small tweaks along the way. The basic process will include fund selection, setting the infrastructure, creating a cadence, and monitoring and implementing a harvesting opportunity. How exciting! Let’s go:
Selecting Funds for Tax Loss Harvesting
When setting up your portfolio for tax loss harvesting, you will want to find a primary fund and a secondary fund for each asset class you want to harvest. For example, I like to keep my portfolio simple with just a domestic equity fund and an international equity index fund. That means I will need to pick out 4 total funds to implement this strategy (2 domestic, and 2 international).
Good rules of thumb for selecting your funds are:
- You would be happy to hold either of the funds indefinitely
- The funds are highly correlated with each other, but
- They track different indexes
Let’s talk about point #3 real quick… the IRS uses the term “substantially identical” when providing guidance on which funds will trigger a wash sale if purchased within the +/- 30 day window. But there is no clear definition on what it means. The generally accepted interpretation is that the two funds must not track the same underlying index. We will use that interpretation for this process.
OK, so now we get to look for funds that meet those criteria. Here are the ones I will use for the process:
Domestic Primary: FZROX
No surprise here, we are going to put that brand spanking new free mutual fund to work in this strategy. You will notice the index that it tracks is their own Fidelity U.S. Total Investable Market Index. They explain their methodology here, but at the time of this writing, it holds around 3,000 stocks in the same market-cap weighted methodology as other common indices. This helps explain why they are able to offer this fund for free, because they are able to avoid any licensing fees to use the index-tracking methodologies of other indices.
Domestic Secondary: FSTVX
With the recent change to “zero minimums” across the board for Fidleity index funds, FSTVX became even more affordable, at an expense ratio of only 0.015%. This was previously held as their “institutional class,” which has been made available to everyone! Also notice this fund is tracking the Dow Jones U.S. Total Stock Market Index, which should pass any checks for the wash sale rule, so we are good to go on the domestic side. We have 2 solid funds that have rock bottom expenses, excellent diversification, and extremely high correlation despite tracking different indices. Check, check, check. Let’s move on to international funds:
International Primary: FZILX
No surprises here, we are utilizing Fidelity’s new zero expense offering, their Fidelity ZERO International Index Fund for our primary here. Like its domestic brother, FZILX tracks a Fidelity-born Global ex U.S. Index, which should make it an ideal candidate to pair up with the upcoming secondary:
International Secondary: FSGSX
The Fidelity Global ex U.S. Index Fund is another beneficiary of Fidelity’s new policy – dropping its expense ratio by about 50% down to 0.06%. This is an incredibly low cost for an international index fund, even compared to Vanguard’s Total International Fund at 0.17%.
You’ll also notice that the Fidelity fund tracks the MSCI ACWI ex-USA Index, which again should be plenty different from the Fidelity offering to not bring any wash sale fears about.
Portfolio Infrastructure for Tax-Loss Harvesting
Now that we have selected our portfolios to harvest, there are two key steps to set your portfolio to support this strategy in the simplest, laziest way possible.
Step One: IRA Fund Selection
The first step is to select different funds to hold in your IRA accounts. The reason for this is because the wash sale rule is account independent – this means that you can trigger a wash sale in your taxable account when you reinvest dividends in your IRA! Not good. The easiest way for me to avoid this problem is to simply track different indices altogether in those account. Again, some good domestic options are:
FXSIX: Fidelity S&P 500 Index fund – 0.015% expense ratio
FSTPX: Fidelity Mid Cap Index Fund – 0.025% expense ratio
FSSSX: Fidelity Small Cap Index Fund – 0.025% expense ratio
How you choose to mix-and-match these is up to you. For simplicity, you can simply leave out the smaller cap funds and keep the S&P, or you can get as complicated as attempt to replicate the total stock market composition manually. The world is your oyster, but all of these funds are fine choices for inclusion in your IRA.
On the International Side, you have 2 other good options as well:
FSPNX: Fidelity International Index Fund – 0.045% expense ratio
FPMIX: Fidelity Emerging Markets Index Fund – 0.08% expense ratio
By investing in separate funds in your IRA’s, you avoid the possibility of a wash sale being triggered here. It is not 100% necessary, and you could choose to invest in the exact same funds as in your brokerage account, but it opens up additional room for error, which I don’t care for.
Step two: Disable Automatic Dividend Reinvestment
Let’s revisit the timeline real quick:
Remember it’s bad news if you buy the same stock +/- 30 days from the sell date. That includes automatic dividend reinvestments! So to avoid a dividend wiping away your sweet tax savings, it’s best to go into your account and disable them for your brokerage account. Here’s how to do that real quick:
1. From your Account Summary Screen, click on Account Features
2. Under Brokerage & Trading, select Dividends and Capital Gains
3. In your taxable account, select one of your funds and click Update
4. Update your preferences to deposit your dividends and capital gains to the Core Account. Be sure to check the boxes below too to ensure the settings apply to all future purchases as well! Click update when done.
5. Verify that the new settings have been updated in the previous screen:
NOTE: If you choose to keep your IRA’s invested in the same funds, repeat this process for those funds as well. You will need to manually invest the dividends based on the schedule we will discuss in the next steps. If you changed to different funds, you can continue to reinvest those dividends automatically.
Creating a Cadence for Tax Loss Harvesting
As you can already see, there are several steps involved in tax loss harvesting, so it’s important for me to keep things as simple as possible. I invest on a monthly basis, at the beginning of the month. So even if the markets tank in the middle of the month, I will (almost always) wait until my next scheduled investment time to harvest the loss.
The reason for this is to avoid that pesky 30 day period as much as possible, and to simply avoid over-tinkering with my accounts. You are welcome to check in more frequently, but I would weigh the pro’s and con’s of spending even more time on your portfolio.
Harvesting A Loss In Fidelity and Keeping Track
Finally, where the rubber meets the road! After all the prep work you’ve done, you’re now ready to harvest your first loss! It all starts with the markets taking a significant loss – that can be 5%, 10%, 15% – you get to decide. Let’s go through this example below:
View your positions and find a position that is trading at a loss
Popping into my account today, I see that my FZILX position is trading at a loss of 3.6%… I would probably not harvest losses so small, but for the sake of this example, let’s say we are ready to harvest this loss. The next step is to …
View the specific tax lots of the position to identify which shares you want to sell
Click on the ticker symbol to expand down your options, and click on “Purchase History / Lots (1). This will show all transactions you have made for this particular symbol. Since this is a brand new fund, I have only made one purchase into the fund on 8/6/2018 (2), and thus far that set of 500 shares is down by 3.6% (3).
Now there are a couple of key takeaways here. The first is that this specific tax lot is only about 10 days old at the time of this writing, which is less than the wash sale’s 30 day minimum for selling at a loss. That means that this is actually NOT a good candidate for a tax loss harvest opportunity. We would need to let this trade sit until at least 9/7/2018 to be safe to harvest the loss.
This can be a little difficult to track manually, so I have put together a free and simple tracker to help you manage your positions:
So even though this is actually NOT an ideal example to harvest, the markets haven’t really given me another opportunity (good problem to have), so we will continue the example. Simply pretend that this fund was purchased 30+ days ago.
Select Trade and choose a Full Page Ticket
Because we are going to pick the specific shares we want to sell in this example, you will need to enter a full page ticket for the process.
Select an Exchange Trade
One of the nice things about using mutual funds (over ETFs) is your ability to do both parts of the trade (buy/sell) in a single transaction. This reduces error and makes this process nice and repeatable. Select “Sell a Mutual Fund and use the proceeds to buy another mutual fund.” Hit Continue.
Fill out the full page ticket with the specific shares option
Fill out the ticket, and be sure to click the “Choose Specific Shares” options so that you can select exactly which shares you want to sell on that ticket. If you do not select that option, you will simply sell the oldest shares first – which is not the goal here!
Enter in the number of shares that are in the specific lot you want to sell, in this case, just a bit over 500 shares. Also enter the fund you want to exchange into (from primary to seconday, or vice versa). If you already have a position in both funds, you will be able to select it from the drop down above. When you’re ready, click Continue.
Confirm you are switching to specific share trading
The next screen may seem intimidating, but it isn’t. Definitely read over it and understand what’s going on. It’s just telling you that the default way Fidelity calculates your cost basis is by taking all the individual trades you’ve made in a particular fund, averaging all the individual cost bases, and reporting out the average. And by converting to specific shares, you will have a cost basis for each trade made in a security. This is exactly what we want here. Click Convert Basis to continue.
Confirm your transition to Specific Share Cost Basis
This rather scary looking consent form just reinforces that you are switching to the speciifc share cost basis. This will need to be reflected on your end of year tax reporting, which is exactly how you will claim the tax losses to offset your income taxes.
Disclaimer: Look, I do this stuff myself, but I am not a tax professional, and this is not specific tax advice for you. If you have any concerns or are unsure, definitely reach out to your tax professional. Just had to put that out there!
Click continue and we will keep marching on!
Select All Funds and enable future funds to follow the same management
Now once you have clicked continue and confirmed these changes, it may take a day for Fidelity to process the change depending on when you initiate the process.
Open a new trade window and note the quantity of shares you want to sell
This is where the normal process will start once you have confirmed specific share management. Again, find the stock you want to TLH with, and click Purchase History / Lots, and take note of the lot you want to sell. In this case, I am going to harvest the losses on the 500.501 shares purchased on 08/06/2018. I like to copy the Quantity value so I make sure to sell the exact amount. Click trade, and open a full page ticket like we did before.
Again we will sell a fund and use the proceeds to buy another. Click continue.
Fill out the trade ticket
Fill out the ticket, and make sure that you put in the exact shares of the lot you want to harvest (1), click “Choose Specific Shares” (2), select the correct fund (3), and click continue (4).
Select your specific tax lot to sell
This screen will let you choose how to identify the specifics shares you want to sell. Since the act of tax loss harvesting is essentially taking a high cost basis position, and reducing that position (buy high, sell low), I like to pre-fill the sort by the highest cost shares first. This becomes helpful when you have many lots within the same position. Click Next.
Here you will confirm that you are selling the correct tax lot.
Before you click past this screen, I recommend you log this transaction using my free spreadsheet. It will make managing this basically automatic and you won’t waste any time doing it:
Simply fill in a new transaction record (1) where you select the fund you sell and buy, and the total losses captured (from the Unrealized Gain/Loss column above).
The spreadsheet will then tell you the next date you can buy or sell those funds again to avoid the wash sale (2), and will keep a running tally of how much you tax loss harvested from each ticker over time (3). Pretty useful!
By keeping up with this, when I think there is a worthwhile harvesting opportunity (major market correction), I check the spreadsheet first to confirm I’m able to do the trade, before I waste my time clicking around in Fidelity. Big time saver over time!
Preview the order and let it fly!
When you preview the order, you will see the final review screen:
As I mentioned before, this transaction has NOT sit for the 30 day period, and I did that on purpose for this tutorial. Notice at (1) and (2) that Fidelity is warning us the 30 day period hasn’t passed yet. They classify it as a “round trip,” not a “wash sale.” A round trip is simply a safeguard policy Fidelity puts in to prevent overtrading, but for our benefit, it serves the same purpose for defending against wash sales.
If you see this message, DO NOT PLACE THE TRADE. You will not earn the tas losses, and you could eventually be suspended from purchasing that fund. Simply wait for the right time and evaluate. But if you have kept up with your timing and you don’t see these error messages, simply place the order, and enjoy your juicy tax savings at the end of the year!
Things To Be Aware Of When Tax Loss Harvesting
As you proceed through this process, make sure you pay attention to the following:
- Dividend Reinvestment. Every time you reinvest dividends, it restarts the 30 day clock for your wash sale timeline. Get around this by electing manual dividend reinvestment, and simply doing the transaction together with your tax loss harvesting (or on a monthly basis if there are no TLH opportunities).
- Fund Selection. For simplicity I prefer to keep the funds in my IRAs and my Taxable accounts different to avoid any wash sale triggers there, especially if you are investing into them every 2 weeks with your paycheck.
- Don’t overdo it. Tax loss harvesting can be powerful over time, but it’s important to remember it is a side benefit of your overall investing strategy. It is not the strategy itself. Remind yourself to focus on your asset allocation, your savings rate, and keeping your costs low overall. Harvesting tax losses should come second, and should not distract you from the overall goal.
Will You Be Tax Loss Harvesting?
I hope this tutorial has been helpful and has prepared you to even further optimize your investing strategy. Today we have so much to be thankful for in the personal finance community. Zero fee index funds, easy technology to optimize our tax situation, and an amazing community around us to help us become financially independent. So I ask you, will you be trying to harvest your tax losses on your own? Leave a comment below!