Long term capital gains tax question

[AK]

Currently, I have around 10,000 in cash in my emergency fund. Next year, I plan on finally having enough income to max out my ira, HSA, and 401k. I don't have a brokerage account yet and am thinking about opening one today at vanguard. My dw and I will remain in the 15% bracket so I don't plan on paying taxes after a year.

Where I get a little lost is how the mechanics work with what's considered long term and short term gains from positions that are taken over time. My plan is to invest in vanguard mutual funds such as the total stock market and a bond fund. If I put money in those today, I don't expect to have to pay any taxes for this year on any positions because these are supposed to be very tax friendly and it's unlikely there will be any realized gains or dividends a few days before the new year. If I continue to put money into the same positions and possibly rebalancing between them in future years, those contributions would still be considered long term because I invested today, right?

I figure why not secure the long term time period at a time when it's unlikely to have any tax consequences and before I get higher income. What do you think?

[secondcor521]

Wrong.

Whether a capital gain or loss is short term or long term is determined based on how long you have owned the particular shares you are selling.  Unless you specify otherwise in advance, the law and the IRS assume you are selling the shares you have owned the longest.  So each individual purchase that you make starts the capital gains/loss clock on those particular shares (often called a "lot" of shares...for example, the January 23, 2014 lot of VFINX...even if you only bought a few shares, it's still referred to as a "lot").  If you hold the shares for more than a year, then your sale is taxed as a long term capital gain or loss.  If less than a year, then your sale is taxed as a short term capital gain or loss.

Rebalancing in a taxable account is considered a sale followed by a purchase, and the sale is subject to capital gain/loss taxes regardless of the fact that you subsequently purchased other investments.  The purchase of the other investment starts a new capital gain/loss clock on those shares, regardless of how long you held the first investment.  In other words, if you own VFINX shares for 10 years, then sell them to buy VTSMX shares and then sell those VTSMX shares six months later, you would owe long term capital gains/losses on the VFINX shares and the VTSMX share sale would be taxed as a short term gain or loss; it doesn't in any way "inherit" the 10 years from the VFINX holding.

Bottom line, you need to treat each set of shares that you purchase individually.  (There is something called an average cost basis that you can use if you want to, in which case you do treat everything as one big lump, based on your total cost and the total shares.  This is a simpler way to do things, and I believe mutual fund shares qualify for treatment this way.  You may end up paying slightly higher taxes going this route.)

You might want to read the IRS topic:

  http://www.irs.gov/taxtopics/tc409.html

I do agree that if you have an emergency fund and are maxing out all your tax deferred options, then investing left over money into a taxable account is a good idea.

Good luck!

[AK]

secondcor521,

That makes complete sense. Thank you very much for clearing that up and providing the IRS reference.