I'm waiting for one more really bad day in the stock market to sell all my shares in an index mutual fund.
Am I insane for wanting to sell at the bottom of the market? Hardly. My two-step plan allows me to trigger valuable tax losses while lowering my investment management costs.
You might want to consider doing the same if you have shares in a stock index fund, as long as you bought them in recent years -- so that the market's slide in the last year has put the investment in the red.
The trick to it is this: You sell a fund to trigger capital losses, then immediately buy one or more funds that mimic the portfolio you just unloaded.
Let's say you bought a $90,000 stake in Vanguard Total Stock Market Index mutual fund at the end of 2007. Thanks to plunging stock prices, your $90,000 stake is now worth about $53,000, giving you a $37,000 unrealized loss.
If you sell now, that loss becomes tax-deductible, although the rules for deducting it are a bit complicated. If you're fortunate enough to sell some other investments at a profit this year, you can use the entire $37,000 loss to offset your 2008 capital gains. That would save you as much as $5,550 in federal income tax when you file your return in April (based on a 15% capital gains tax rate) and would probably lower your state income tax bill as well.
If you don't have any gains to offset, you can use up to $3,000 of your capital loss to offset ordinary income each year. If your combined federal and state tax bracket is 30%, this would save you $900 a year for 12 years, plus $300 in the 13th year, for a total savings of $11,000.
That's the first step. The second step is to immediately reinvest your money in a very similar portfolio to ensure that you're not falling into the trap of selling a holding that has plunged in value in exchange for securities that have held up better.
You can't invest in Total Stock Market Index again because tax rules bar you from claiming a capital loss on the sale of an investment if you turn around and buy "substantially identical" shares within 30 days.
Instead, you can seek to replicate the portfolio you just sold. Because Total Stock Market Index is designed to track an index of all U.S.-traded stocks, you can mimic it by putting 90% of your proceeds in Vanguard Large-Cap ETF and 10% in Vanguard Mid-Cap ETF.
Here's how the old and new portfolios compare:
