Harvesting the Fall: Why I Sold All My Bonds

Beginner, Theory

Investing is like riding a skateboard. It takes skill, balance, lots of practice, and a certain amount of fearlessness. You know for a fact that you’re going to fall sometimes, and yet you do it anyway because you understand that perseverance pays off. Still, even the best skaters know when and how to bail gracefully without getting hurt.

With bonds cratering this year amid rapidly rising interest rates, that portion of my portfolio is currently a sea of red. Bond purchases going back a full decade are suddenly underwater, and after surveying my options it quickly became evident that it’s time for a big change. So after much deliberation, this week I finally pulled the trigger and sold every long term bond in my portfolio. With a simple click of a button, a big chunk of my total holdings that I’ve depended on for years went straight to my cash balance and I realized a sizable capital loss in my account.

Then a few seconds later, I put all of that money into an extremely similar bond fund with much lower expenses. And I used those capital losses to also swap out my gold holdings with big capital gains completely tax free. The end result is that I took advantage of unique market conditions to maintain the same asset allocation that serves me very well while saving potentially thousands of dollars a year.

What — you thought I bailed on bonds entirely? Please. My portfolio continues to cruise on, and I landed that kickflip like a champ!

Here’s how you can, too.

Table of Contents

Just so there is no confusion

In this article I am going to talk about taxes and IRS rules. To be perfectly clear, I am NOT a tax professional. I do my very best to be accurate, but taxes are complicated and not every suggestion may apply to you. When in doubt, seek professional advice from a tax expert who can look at your personal situation in detail.

Also, I fully admit that much of this article will skew US-specific in terms of tax laws. Even if you live outside of the United States you may find the thought process educational, but if US taxes don’t interest you then you can skip ahead to the cost-reduction insights that apply to everyone.

Setting annual goals

As temperatures finally cool, this is the season when diligent portfolio managers evaluate their options and decide on necessary changes before the end of the tax year. There are lots of things that may make sense, including catching up on 401k contributions, doing a Roth rollover, or determining simple tax maneuvers that can allow you to maximize ACA subsidies. While many of those items may not matter to you right now, there are three activities that all DIY portfolio managers should consider annually:

1. Rebalancing your portfolio

2. Reducing fees

3. Minimizing taxes

Rebalacing is the act if selling the assets above their target percentages to buy more of the ones below their target. Not only does this help to minimize risk, but it also helps to improve the risk-adjusted returns of your investments. Reducing fees can be accomplished by keeping an eye on the latest fund options and choosing funds with the lowest expense ratios. In a competitive market, these can change way more often than you think.

But the problem with both rebalancing and reducing fees is that they involve selling assets. If you’re talking about a retirement account, you can do so without worry because the transactions are tax free. But if you’re working in a taxable brokerage account, you have to be really careful. Because depending on what you’re selling, when you bought it, and a myriad of other variables that the tax authorities track, the tax bill from any sale can be quite expensive.

When I evaluated my own portfolio, I found that it was already reasonably balanced with no action needed. So for my most recent move, I had two primary goals: reducing fees while minimizing taxes.

And that’s where the bonds came into play.

The benefits of tax loss harvesting

My oldest long term treasury holdings were more than 10 years old, and at the time the best option was the ETF TLT. With an expense ratio of just 0.15%, it has served for a long time as a great choice in my portfolio that I personally like more than manually managing a ladder of directly-held bonds. But the ETF market has gotten a lot more competitive in the last decade, and the benefit to investors is the pressure that the competition places on fees. Similar long term treasury fund options like SPTL now have expense ratios of only 0.06%, which is less than half of the TLT alternative.

So why have I held onto the more expensive fund for so long? That one is easy — taxes.

I certainly can’t speak for every country, but in the US investments are taxed based on two things: income and capital gains. Income results from regular payments like stock dividends and bond interest. Capital gains result from selling an asset for more than you paid for it. The difference between the selling price and what you originally paid (also known as the cost basis) is what matters — if you made money it’s a capital gain, and if you lost money it’s a capital loss.

The percentage of any capital gain that you owe in taxes once you sell varies by how long you’ve held the asset. Hold it for more than a year, and you qualify for long-term rates as low as 0% in some situations. It also varies by your personal income level and occasionally the asset type, with things like stocks and bonds seeing a max rate of 20% and gold with a max rate of 28%. The nuance of every situation is far beyond the scope of what I can succinctly summarize here. But for the purposes of this discussion, just know that my capital gains in long term bonds over the years were sizable. If I sold them, the taxes would have far outweighed any savings in the expense ratio for quite some time.

Until this year.

2022 has been a truly rough year for long term bonds. The losses have been so substantial that they’ve not only created big capital losses for bond holders but they’ve even crept my old long-held bonds into the red. So while others may be panicking about bonds, I looked around and saw a new opportunity. For the first time in ages I could completely switch bond funds with a loss, making the move tax free.

Beyond not paying capital gains taxes, the capital loss has a measurable positive tax value of its own. That’s because capital losses in one asset can be used to directly offset capital gains in another asset. Smart money managers have long taken advantage of that IRS rule by actively collecting losses in some funds to offset gains in others, which is where the term “tax loss harvesting” comes from.

So that got me thinking — what other funds have I been hesitant to swap out for cheaper options due to the tax consequences?

For me, the obvious answer was gold. IAU has long been my personal gold ETF of choice, as it’s highly liquid with an ER of 0.25%. But in the last few years the competition in the gold ETF space is some of the fiercest I’ve seen, and new offerings like GLDM now have expenses as low as 0.1%. You can see why they have my attention. While my capital gains in gold might normally dissuade me from making any changes, it just so happens that my capital losses from switching bond funds completely offset those gains with a little room to spare.

So long story short, swapping TLT for SPTL during a down year in bonds allowed me to accomplish several things. First, it immediately reduced the fees for my bond fund by 60%. Second, tax loss harvesting bonds to offset gains in gold allowed me to also reduce my gold expenses by the same percentage. My asset allocation didn’t change at all, and I did it all without paying a single extra dime in taxes.

Not bad for a few minutes of work.

How to avoid wash sales

While the process of tax loss harvesting is not particularly complicated, there are definitely limits to what you can do. When swapping one investment for another with the intent of harvesting capital losses to reduce your tax bill, there are a few rules that must be followed.

1. You can’t immediately buy back the original investment without waiting at least 30 days.

2. You also can’t have purchased the same investment for 30 days prior to your sale.

3. Even if you buy a different investment during that 60-day window, it can’t be “substantially identical” to the one you sold.

Breaking any of those rules results in what the IRS calls a “wash sale”. It’s not the end of the world, but the important thing is that it prevents you from using your capital loss to offset your taxes owed.

Rules 1 and 2 can be met by patiently avoiding purchases near your sale, although it can be a little trickier than it sounds. If you have your brokerage account set to automatically reinvest dividends and interest every month, that counts as a purchase! So to be safe, the best solution is to turn that feature off and always have that income paid into cash for you to manage manually. Also, purchases made even in a different account such as an IRA or your spouse’s separate investing account will trigger a wash sale by IRS rules. So always look at your entire family holdings as one account for tax purposes.

Rule #3 gets a little more complicated, as the official definition of “substantially identical” is rather vague. Obviously selling one stock and buying the identical ticker is disallowed, but when talking about index funds there’s a bit of a gray area. Are two stock funds from different providers that track the same thing substantially identical? Well, the devil is in the details.

Consider three long term US treasury bond funds: TLT, SPTL, and VGLT.

If you sell TLT at a loss and buy SPTL or VGLT just a few minutes later, you’re just fine from a tax perspective. But if you sell SPTL at a loss and buy VGLT, there’s a good chance that it will trigger a wash sale and your tax loss harvest will be disallowed. That type of mismatched tax treatment even among index funds following the same asset class and with extremely similar returns is one of the things that makes tax management so confusing. So what’s going on?

While the IRS is notoriously cagey on exactly what counts as “substantially identical”, the general consensus among tax experts is that the most important thing to pay attention to is the underlying index that the fund tracks. In this case, here are the three funds and the indices that they follow.

TLT: ICE US Treasury 20+ Year Index

SPTL: Bloomberg Long U.S. Treasury Index

VGLT: Bloomberg Long U.S. Treasury Index

As you can see, TLT tracks an ICE index of treasuries with maturities over 20 years. SPTL and VGLT follow the same Bloomberg index of treasuries over 10 years. Even though they’re all long term treasury funds offered by different fund providers, definitions matter. While swapping funds that track different indices passes muster from the IRS perspective, changing one fund for another that follows the same index does not.

Effective fund pairs

If learning about index definitions sounds intimidating enough that you don’t know where to start, the good news is that there are some nice resources out there to point you in the right direction. One of my favorites is this list of investments available at Weathfront.

In case you’re wondering, I have absolutely no affiliation with Wealthfront. That’s NOT an affiliate link, I don’t use their service, and I’m not suggesting that you should. But I appreciate their transparency, and their information is quite useful for all US-based investors.

Among their various services, Wealthfront offers automated tax loss harvesting in their accounts. With their teams of accountants and lawyers, I’m confident they’re up to speed on IRS rules. And even if you don’t invest with them, Wealthfront openly shares not only their primary fund list but also their list of alternative funds that they use for harvesting losses with no wash sale issues.

To help you out, I took the liberty of browsing the list and collecting the funds they use for many of the assets found in the tools here at Portfolio Charts.

Tax loss harvesting pairs

Comparable ETFs used by Wealthfront to avoid wash sales

Asset ClassPrimary ETFAlternate ETF
Total Stock MarketVTISCHB
Large Cap BlendSPYIWB
Large Cap ValueVTVMGV
Large Cap GrowthVUGMGK
Small Cap BlendSCHAVTWO
Small Cap ValueVBRIWN
Small Cap GrowthVBKIWO
Total DevelopedVEASCHF
Developed ex-USVXUSVEU
Emerging MarketsVWOIEMG
Long Term BondsVGLTTLT
Intermediate BondsVGITIEI
Short Term BondsSCHOSHY

Now obviously that list is not comprehensive of every asset class or good fund option for each asset. And since I’m not a tax professional, I also can’t personally vouch for every choice. But when looking for fund options for your own tax loss harvesting plan, I do think it’s a nice starting point for further research. For example, while I didn’t personally choose VGLT as my TLT alternative, knowing that VGLT is a safe trade was extremely illuminating since I also understood that VGLT and SPTL follow the same index.

So please don’t follow that list blindly, and always do your own research. But hopefully that helps get you started on the right track.

Measurable cost reductions

While tax machinations are educational, the more fundamental portfolio cost issues are far more long-lasting than a single tax filing. And it’s also truly universal beyond US shores. Fund expenses add up!

If this is the first time you’ve thought about expense ratios in a while, I have a nice tool that may help called the Fund Finder. It allows you to scan multiple ETFs for every asset to quickly identify the cheapest available options, and it even works for countries outside of the US. For a full explanation, read this:

But for a quick example pertinent to this discussion, let’s put the tool to good use. To keep it simple and scalable, think about a hypothetical investor with their money invested in the Golden Butterfly. Pay close attention to the total expense ratio with a Golden Butterfly using TLT and IAU versus SPTL and GLDM.

Detail-oriented readers may notice that the gold fund GLDM lists an expense ratio of 0.18 even though the current ER is only 0.10. SCHO is also a little out of date as well. That’s simply because funds are always updating their fees while I update them all at once at the new year. While thinking of it as a good reminder to always do your own research, also know that once I do update everything the Total Expense Ratio will show the optimized portfolio with an ER of 0.06%. That’s a savings of 0.05% a year from the 0.11% baseline.

Five hundredths of a percent is a small number that may not sound like much. But when applied to your life savings it can really add up. That works out to $50 a year for every $100k invested. If you’re a young investor with a newly growing portfolio, would you turn down a free Netflix subscription for life? And if you’re on the FIRE path seeking early retirement, how much better would your safe withdrawal rates on your $2mm portfolio look with a thousand dollars less in expenses every year? Forget the meme of brewing your own coffee to save money — that’s a lot of cash to reinvest without even lifting a finger past choosing a better set of funds.

The measurable savings made plenty of sense to me, and more than justified the minimal amount of effort required to make a transition plan and pull a few brokerage levers. And that’s even coming from one low cost ETF to another. If you happen to be currently invested in high-expense funds closer to 1% than 0.1%, then the potential cost savings of finding a good index fund could be huge. Take the time to look at your options in detail, and your future self swimming in extra savings will thank you later.

Taking the next step

If you made it this far and are naturally wondering how much money you can save every year, here’s a quick summary of steps you can take today to get the most out of your investments.

1. Play with the Fund Finder to identify low-cost ETF options for your portfolio. Look at the difference between the ideal ER and your current ER, and multiply that by your portfolio value. That’s how much you could potentially save every year in fees.

2. If you’re investing in a tax-deferred account, switch to the less expensive funds and enjoy the savings!

3. If you’re investing in a taxable account, take your time to make a plan. Visit your brokerage website and find the gains and losses for your individual asset lots. Think about which things you can change now because of losses and how you can use those losses to change others with gains. When in doubt about your tax liability, play with tax planning software or talk to an expert to go over your options.

4. Set your plan into action. Be patient, and make sure to avoid wash sales that could negate all of your hard work.

5. And when it’s all done, sit back with a refreshing beverage and think about how much money you kept in your own pocket rather than unnecessarily surrendering it to the financial industry every year.

Market drama and asset allocation may get most of the investing headlines, but there’s more money to be made in the trenches with proper tax management and fee optimization than lots of people realize. You’re smart, capable, and empowered to make it happen. Dig into the details, and even if it doesn’t make sense to change anything now I guarantee your effort will eventually pay off.

Did this article save you a bunch of money in taxes and fees?

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