Week 42 Day 3: Tax Lot Accounting: Choosing Which Shares to Sell

You bought VTI at different times: 100 shares at $200, 100 shares at $180, 100 shares at $220. The current price is $190. Your brokerage default might sell the oldest shares first (FIFO). But the shares bought at $220 have the biggest loss ($30/share vs. $10/share). Specify those shares to sell and you harvest 3x the tax loss.

Tax lot methods: (1) FIFO (First In, First Out). Default for most brokerages. Sells the oldest shares first. Often the worst choice because the oldest shares usually have the lowest cost basis (biggest gains), resulting in higher taxes. (2) LIFO (Last In, First Out). Sells the newest shares first. Can be good if recent purchases were at higher prices (bigger losses). (3) Specific Identification (Spec ID). You choose exactly which shares to sell. The optimal method because you can always pick the shares that produce the best tax outcome. (4) Average Cost. Allowed only for mutual funds (not individual stocks or most ETFs). Averages the cost of all shares. Simpler but less tax-efficient. Setting up Spec ID: (a) Contact your brokerage and change the default cost basis method to 'Specific Identification.' (b) When selling, specify the lot (identified by purchase date and price). (c) Keep records of the specification (most brokerages do this automatically). (d) For tax-loss harvesting: specify the lots with the HIGHEST cost basis (biggest losses). (e) For selling winners (to raise cash): specify the lots with the LOWEST cost basis held for more than one year (long-term capital gains rate of 0/15% vs. short-term rate of up to 37%). The tax lot optimization can save 0.5-1.0% in annual tax drag on a regularly traded portfolio. For buy-and-hold index investors, the benefit is smaller (fewer transactions) but still meaningful during tax-loss harvesting events.

Tax lot optimization is a form of tax-efficient withdrawal sequencing. The general principle: always sell the lots that produce the most favorable tax outcome. For loss harvesting: sell the highest-basis lots (largest losses). For gain realization: sell the lowest-basis lots held for 12+ months (qualifying for long-term capital gains rates of 0/15/20%). The long-term vs. short-term distinction is critical: short-term capital gains (assets held < 12 months) are taxed at ordinary income rates (up to 37%), while long-term gains are taxed at preferential rates (0% if taxable income < $89,250 for married filing jointly in 2024, 15% up to $553,850, 20% above). The 0% long-term capital gains bracket is particularly valuable: investors with taxable income in the 10% or 12% ordinary income brackets pay ZERO tax on long-term capital gains. For a retired couple with Social Security as their primary income, strategically realizing long-term gains to fill the 0% bracket can extract tens of thousands of dollars from taxable accounts with no federal tax liability. The computational optimization of tax lot selection across multiple accounts, asset classes, and tax rates is a complex integer programming problem that software (TurboTax, tax planning tools, robo-advisors) handles effectively. For manual optimization, the heuristic is simple: when harvesting losses, sell the highest-basis lots; when realizing gains, sell the lowest-basis lots held over one year.