Help with Tax-Loss Harvesting

Tax-loss harvesting has become a time-honored tradition among many mutual fund investors. As my colleague Larry Swedroe has pointed out, it's something that investors should keep an eye on throughout the year. But despite that, many only really begin to focus on it as the calendar approaches year-end. So this week, I thought I'd address those investors who are considering harvesting some of their investment losses.

What is tax-loss harvesting? Simply, it's selling an investment at a loss with the intention of ultimately repurchasing the same investment after the IRS's 30 day window on wash sales has expired.

Why tax-loss harvest? Tax-loss harvesting allows you to use investment losses to lower your tax bill. These losses -- which are realized by selling the investment -- can be used to offset an unlimited amount of investment gains, or up to $3,000 of income. Any losses that are unused in a given year can be rolled over and used in subsequent years.

When should you consider harvesting your losses? The strategy is particularly useful when you have a large investment loss, which is why it makes sense to be prepared to harvest losses at any point during the year. You should also consider harvesting losses when you have realized a large investment gain, or otherwise believe that your tax liability in a given year will be higher than normal.

When should you think twice about tax-loss harvesting? First and foremost, you might pass on harvesting if in doing so you would incur sales loads or transaction fees on either the sale or subsequent repurchase of your original fund. Also, you should think twice about tax-loss harvesting if you expect your future tax rate will be higher than your current one. The Wall Street Journal's Jason Zweig had an excellent column recently that discussed the possible downside of frequent tax-loss harvesting.

Where should I park my money? In order to realize your loss, IRS rules state that you cannot purchase either the fund you sold or the shares of a substantially identical fund for 30 days after the sale. What constitutes a "substantially identical" fund is a bit tricky to say, because the IRS has not formally defined it. I've read some experts who say that selling one firm's 500 index fund for another firm's 500 index fund won't trigger a wash sale. Perhaps that's true, but personally I would tend to be a bit more conservative in such a decision, just in case I ever find myself defending the transaction to an IRS auditor.

In choosing a place to park your money while waiting out the wash period, the most important consideration is finding a replacement that will closely mirror the performance of the original fund, thus ensuring that you don't incur an opportunity cost.

Index fund investors have the most straightforward decision; they can simply purchase a fund that tracks a similar -- but not identical -- market benchmark. If your fund follows the S&P small-cap growth index, for instance, you could use a fund that tracks the Russell 2000 small-cap growth index as your 30 day replacement.

Investors in actively managed funds have a less-straightforward decision. You could certainly substitute a different actively managed fund, but there's no guarantee that your replacement fund's performance will mirror that of your original investment. Fortunately (in this case), most actively managed funds closely track one index or another. For that reason, perhaps the best substitute is an index fund that tracks that index. Exchange-traded funds, tracking a broad array of market indexes and offering immediately liquidity, are ideally suited for this purpose.

So how do you determine which ETF is an appropriate substitute? The first place to start is to look up your original fund on Morningstar.com. There, you can find your fund's "best fit" index -- that is, the index that it is most highly correlated with. In most cases, the best fit index will be an S&P or Russell index, which have highly liquid ETFs tracking them.

In some cases, however, you might find that the best fit index is a lesser-known one, such as one of the Morningstar equity indexes. And while there are in many cases ETFs that track these indexes, they tend to be a bit less liquid than those that track the more popular indexes. In such a case, you might be better off using a more liquid ETF that tracks the S&P or Russell indexes.

In the table below, I've listed the three largest non-index funds in each of the nine Morningstar style boxes, along with their best fit index, which you can use to begin your hunt for an ETF substitute. In the likely chance that your fund is not listed below, simply look up your fund's best fit index under its "Ratings & Risk" section on the Morningstar website.

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