Worse than the wash sale rule? Betterment's head of investing weighs in.
Tax-loss harvesting municipal bond ETFs within 6 months could mean some losses are permanently disallowed
Elie Rozner and I teamed up on this piece. This article is for general education. Not advice. Not a recommendation to buy or sell any security or adopt any investment strategy. Consult an adviser about your specific circumstances.
Tax-loss harvesting with municipal bond funds has a little-known pitfall we call the 6-month rule
When investors sell shares at a loss after holding for 6 months or less, the loss is permanently reduced by an amount equal to the tax-exempt distributions the fund paid on those shares. Here’s an illustration of an example from IRS Pub 550.
We called this rule a “cousin” to the wash sale rule in our previous post on the 6-month rule.
Since the loss is permanently disallowed, it’s roughly equivalent to the wash sale case where investors sell to harvest a loss in a taxable account and buy in an IRA or Roth IRA. In a typical wash sale, the loss is deferred. In the IRA/Roth IRA case, the loss is gone forever.
Some muni funds are exempt
The good news is that the rule doesn’t apply to all muni funds.
IRC Section 852(b)(4)(E)(i) carves out an exception for “daily dividend” funds, defined as funds that declare dividends every day and pay them at least once a month.
Investors can always deduct the full loss from selling a daily dividend muni fund, even one purchased within the past 6 months.
What does it mean to declare daily?
Most dividend-paying funds declare periodically (e.g., monthly or quarterly) and announce a record date. Shareholders of the fund on the record date receive the entire dividend, regardless of when they purchased the fund.
Take SGOV, for example, a short-term Treasury ETF that declares dividends monthly.
Interest accrues every day, but that accrual takes place within SGOV, which causes the price to tick up by a few pennies per day. Then, once a month on ex-div day, the price drops by the amount of the distribution, one whole month’s interest.
Here’s a price chart of SGOV over the last year. Notice the steady rises followed by sharp declines.
Daily dividend funds operate differently
Instead of having periodic record dates, every day is a record date.
Shareholders of record on March 6th are credited one day’s interest. If they hold through March 7th, they get another day’s interest.
At the end of each month, the fund pays out whatever interest it owes based on the number of days during the month that an investor held.
Different shareholders will receive different month-end payments based on their respective intra-month holding times.
VMFXX, Vanguard’s federal money-market fund, is a daily dividend fund.
It invests similarly to SGOV, but instead of interest accruing within the fund, it accrues directly to the investor every day.
That’s why the fund’s price doesn’t tick up daily to reflect internally accruing interest, and consequently, doesn’t have a price drop once a month either.
Here’s a price chart of VMFXX over the last year:
The 6-month rule was designed to prevent tax arbitrage
Without it, investors could buy a muni fund the day before the ex-date and sell it on the ex-date.
They’d be entitled to a tax-free distribution, but since the price of the fund must drop by the amount of the distribution, they’d also have a capital loss.
If they have other gains in their portfolio, they could use this tax arbitrage to effectively convert those gains into tax-free income.
The 6-month rule disallows the capital loss from selling the fund, so the arbitrage disappears.
For a daily dividend fund, there was never an arbitrage to begin with
If an investor buys the fund the day before it distributes income, they’ll only receive one day’s worth of interest.
There also won’t be a drop to reflect the distributed income, since interest was accruing directly to investors throughout the month, rather than accumulating within the fund.
The predictable jagged nature of monthly or quarterly dividend funds is what creates a potential for tax arbitrage. A daily declaration fund doesn’t have that jagged price action to take advantage of; no tax arbitrage means no 6-month rule.
Which muni funds declare daily?
We gave an example of a money market fund that declares daily, VMFXX, but Vanguard has many municipal funds in a wide range of sub-categories that also declare daily. Some examples:
National funds
Short-term (VWSTX)
Intermediate-term (VWITX)
Long-term (VWLTX)
High-yield (VWAHX)
State-specific funds
California intermediate-term (VCADX)
New York long-term (VNYTX)
If you want to know if a particular Vanguard fund has a daily declaration, look for the words “Monthly – Accruing Daily” in the distribution schedule section on the fund’s website.
We weren’t able to find a single example of a muni ETF that declares daily. As of this writing, investors tax-loss harvesting muni ETFs will always be dealing with the 6-month rule.
What damage could the 6-month rule cause?
To see how much loss could be disallowed, we simulated loss harvesting during 2022, the last major fixed-income bear market1.
The simulation was partly based on this Wealthfront paper on ETF loss harvesting, where they describe their “primary/alternative” approach.
Wealthfront chooses two ETFs from each asset class; one as a primary investment, and one to switch into when harvesting losses from the first.
Wealthfront gives examples of primary and replacement ETFs for each asset class. For municipal bonds, the two funds they use are Vanguard’s VTEB and BlackRock’s MUB.
For our simulation:
We started the year in VTEB and switched to MUB after a 2.5% loss
We then waited at least 31 days and switched back to VTEB when MUB showed a 2.5% loss, etc., until year-end
We were careful not to trigger a wash loss, but completely ignored the 6-month rule
The portfolio started the year with one million dollars
Simulation transactions:
Buy $1M of VTEB on December 31, 2021
Harvest a $25.7K loss on January 31st, 2022
All of the loss was allowed because no tax-exempt income had been paid
Purchase MUB
The 6-month window starts again
Harvest a $24.8K loss on March 14th, 2022
$2.9K was disallowed (~12% of the total loss), as it was attributable to tax-exempt income
Purchase VTEB
The 6-month window starts again
Harvest a $27.6K loss on April 14th, 2022
$1.2K was disallowed (~4% of the total loss)
Purchase MUB
The 6-month window starts again
Harvest a $25.9K loss on May 17th, 2022
$1.5K was disallowed (~6% of the total loss)
Purchase VTEB
The 6-month window starts again
Harvest a $23.1K loss on October 21st, 2022
$7.9K was disallowed (~34% of the total loss)
Purchase MUB one more time
The 6-month window starts again
In total, we naively harvested $127.1K of losses, and $13.5K of them (~11% of the total losses), were permanently disallowed.
A good tax-loss harvesting engine should consider the 6-month rule.
Betterment weighs in
We sat down with Mychal Campos, head of investing at Betterment, to find out how Betterment incorporates the 6-month rule into its tax-aware investing process.
Mychal said that Betterment is well aware of the 6-month rule and is careful not to sell shares that could trigger loss disallowance.
“We don't even process them [municipal bond ETF tax lots held for less than or equal to 6 months]. They are not candidates for tax-loss harvesting.”
Mychal also told us that Betterment has been on top of the 6-month rule for quite a while. “We've been doing this since very early on, to the point where it's Betterment legacy code.”
One case where clients could still run into the rule, even with Betterment’s safeguards, is a withdrawal. Keep in mind that, unlike the wash sale rule, the 6-month rule is triggered immediately when you sell; it has nothing to do with subsequent purchases.
If a client started investing in muni ETFs three months ago and sells today to withdraw, there’s a good chance that there will be some disallowed loss. “We won’t block the withdrawal,” Mychal said.
This is something to keep in mind when transitioning out of investments, even partially. Advisors often try to sell loss shares first when there’s a need for cash.
Doing so could yield surprising results when it comes to muni funds, but this depends on the specific circumstances.
Is your manager even paying attention?
A baseline level of diligence for the 6-month rule is determining whether your manager is even aware of it. If they’re not, they could be triggering disallowed losses and not even know it.
Beyond that, here are a couple more things to keep in mind…
Does your manager report disallowed losses to you?
Treasury regulations don’t require them to do so (see 26 CFR 1.6045-1(7)(iv)). It’s typically the taxpayer’s responsibility to adjust transaction specifics as the 6-month rule requires, so any manager or broker making these adjustments for investors is going the extra mile.
Has your manager considered using mutual funds that declare daily instead of ETFs subject to the 6-month rule?
Unlike most cases where ETFs outperform mutual funds on tax efficiency, the opposite may be true when tax-loss harvesting muni ETFs.
Advantages of individual bonds
Portfolios holding individual bonds don’t have to worry about the 6-month rule because it only applies to funds.
Daily declaration
If you choose your funds from a menu that declares dividends daily, you won’t have to deal with the 6-month rule.
Dotting i’s
The 6-month rule for muni funds is niche but relevant. It could cause a surprise tax liability.
It could also be a differentiator for the tax-aware manager who stays on top of it. At the very least, an approach considering the 6-month rule shows a manager has dotted their i’s and crossed their t’s.
May this man never die
Have a good weekend
p.s. 🔱 The Mariners are playing well, but Big Dumper has become Big Slumper lately. He’s batting just .177 with a .687 OPS since the beginning of July (for non-baseball people, that’s really bad). Somehow, he’s still leading MLB in home runs, but without a fix, that won’t last. 🫠
This is a hypothetical example and may not reflect reality. All investing has risks. Tax-loss harvesting has risks. These numbers do not represent any specific investor’s reality. This is not a recommendation of any process or product. Readers should consult a licensed professional for details about their circumstances.
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