minimizing taxes

Tax-Loss Harvesting (Making The Most Of Your Losses)

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The markets have been hot for a while, and you’ve likely experienced some significant gains in your portfolio.  What options do you have to minimize the taxes associated with those gains?  Today, an expert weighs in with an excellent overview of Tax-Loss Harvesting.  It’s an important concept to understand, and I know of no one better to explain it than Bob French, Director of Investment Analysis at Retirement Researcher (founded by Wade Pfau).

When Bob speaks, people listen.  I encourage you to read his overview of tax-loss harvesting, it’s a tool you should understand as you seek to reap some of the gains you’ve made over the past few years.  I appreciate experts being willing to help teach investment lessons to the readers, and I’m humble enough to say that I learned some things by reading the words that follow.  Hopefully, you will, too.

By the way, Bob will be presenting a valuable webinar: Managing Your Portfolio: The 6-Step Process to Maintaining the Portfolio You Designed, on both May 4 and May 5th. I’ll be attending, and I encourage you to join me.  You can register (for free) by clicking this link

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minimizing taxes

Tax-Loss Harvesting (Making the Most of Your Losses)

It’s no fun when the markets drop.  No one likes losing money, but i’ts an unfortunate (and hopefully temporary) fact of investing.  We know it’s going to happen, so we need to plan for it.  By far, the biggest part of this is setting up your portfolio so that you can stay disciplined and stick it out when the markets aren’t cooperating.  But there’s actually something else that you can do – and you may want to add it to your retirement portfolio management process.
 
You can start looking for Tax-Loss Harvesting opportunities.
 
Tax-Loss harvesting is generally considered one of those “advanced” techniques, but it can be an incredibly valuable tool.  Normally, when I mention tax-loss harvesting, people have one of three reactions:  they either have no idea when I’m talking about, they nod sagely (and then don’t do anything about it), or they run away screaming. But it’s actually not that complicated, and you can do it fairly easily.  You just need to be organized, keep your eye on the big picture, and pay attention to a few rules.  Let’s break this down, and start at the beginning.
 

What is Tax Loss Harvesting?

We all know what capital gains are.  When you are selling something in one of your taxable investment accounts (non 401(k) or IRA), you owe taxes on your gains.  the tax losses that we are harvesting are the other side of the coin.  When you sell something in your taxable account for less than you bought it for you can use those losses to offset your capital gains from other transactions, or even reduce your regular taxable income in the right situations.
 
There are are a couple of things to point out here:
 
1. The losses that you’re taking need to be in a taxable investment account that you normally pay capital gain taxes for.  The government doesn’t really care whether you lost money in your 401(k).
 
2. The loss (or gain) is calculated based on the price that you paid when you bought those specific shares. This is often one of the areas that trip people up with tax-loss harvesting.  Most people don’t think about cost basis accounting all that often (and their lives are better for it), but knowing how your accounts are being handled is incredibly important here.  If you’re selling some shares of Apple stock that you bought back in the ’80s, I’m sorry to say that you probably won’t have much of a loss to work with.  On the other hand, you probably made a truckload of money on that position, so it’s not all bad.
 
3. The financial markets are always bouncing around, so you can often find tax-loss harvesting opportunities in “normal” years, but it really comes into it’s own during years where returns have been extra bumpy, or just plain bad.  Very often tax-loss harvesting is a silver lining opportunity, but you might as well grab that silver lining.
 

How Does Tax-Loss Harvesting Work?

The process of harvesting your losses is simple.  Just like generating capital gains, creating losses is automatic.  It happens as soon as you make a trade.  The difference is that with tax-loss harvesting you are intentionally, and strategically, generating these losses (there are some caveats on that, but we’ll deal with them in a minute).
 
The losses that you generate are then used to offset your capital gains for the year.  As an example, if you have $10,000 in gains, but you realize a $6,000 loss, your net gain would be only $4,000.  As you can imagine, this can be really useful for managing your tax bill.  But the interesting stuff starts happening if you find yourself in a situation where you can have a net capital loss.  For joint filers, you can apply up to $3,000 in capital losses to offset your ordinary income.  Since ordinary income is taxed at a higher rate than capital gains, this is a huge benefit.
 
If you have even more capital losses than you can apply against your ordinary income in a single year, then you can carry these losses forward.  While it may sound nice to keep those losses in your back pocket for a rainy day, you (usually) want to use them as soon as possible.  the reason for this is one of the foundations of finance – a dollar today is worth more than a dollar tomorrow.  If you could choose between receiving $100 today, or in a year, you would want the money today.  It’s exactly the same principle here.  Carry forward losses are nice in theory, but they don’t turn into money in your bank account until you use them.
 

30 day wash rule

Things to Watch Out For

All of this seems straightforward so far.  So where’d tax-loss harvesting get its reputation as an “advanced” strategy?  Well, it’s not completely undeserved.  There are a few pitfalls that you need to watch out for.

The primary one is the Wash Sale Rule.  The wash sale rule says that you can’t buy a “substantially identical” security 30 days before, or 30 days after, the sale you are claiming a loss on.  If you do, the loss will be disallowed.  Essentially, this rule is there to ensure that you really are taking a loss on the transaction, and not just moving money from one pocket to the other (though you can get pretty darn close). But there are three things we should understand in the definition of the wash sale rule.

 1. The timing of when you harvest your loss is crucial, and if your savings are automatically invested this can cause problems.  Before you do your tax-loss harvesting, you need to double-check that you haven’t purchased the security (or one that is substantially identical, which we’ll talk about in a minute) in the previous 30 days, and you can’t buy it again for the next 30 days.  In total, you won’t be able to purchase the security for 61 days.  It’s important to note that this also applies to reinvested dividends, as well as things like stock compensation from your employer (including any stock that you might happen to be vesting).  There is a caveat here though – if you are selling the entire position, you don’t need to worry about whether you bought any shares in the 30 days prior to the sale.

2. The “You” in this definition is pretty expansive.  Not only can you not purchase the security in accounts in your name, but the security can’t be purchased in accounts that you presumably have some level of control over (like accounts in your spouses’ name). If any of these accounts buy the security in that 61 day wash sale window, it’s treated as if you did it and the losses will be disallowed.

3. I’ve used the term “substantially identical” a few times, and it’s an incredibly important tone for the wash sale rule. It’s a little bit of a term of art, but it pretty much means that you can’t buy something with exactly the same risk characteristics of the security you sold for a loss.  But you can get pretty close.  For instance, if you sold shares of an S&P 500 Index Fund, you couldn’t turn around and put that money into another S&P 500 fund, but you could put it into an index fund tracking another large-cap index, like the Russell 1000.

To the last point about buying substantially identical securities, when you harvest losses, you need to decide what you are going to do with the proceeds (ideally you’ll have done this before you make the trade).  you can either hold that money in cash, or some other less risky asset like short-term bonds, and wait out the 30-day post-sale wash sale window, or you can put your money to work in a security that isn’t substantially identical.

The advantage of just holding the cash is that it’s simpler, which can be pretty valuable.  You can just sit on the cash for a month, then reinvest the money back into the security you claimed the loss on when you are out of the wash sale window.  The problem is that all of that money is sitting in cash during that period.  It’s not really doing anything for you over that month.

Alternatively, you can invest the money in something that isn’t substantially identical to what you claimed the loss on.  For example, moving the money from an S&P 500 Index fund to a Russell 1000 Index fund.  This means that the money is staying invested – albeit in a slightly worse option than your original investment (if the new security was a better option, presumably you’d have already been invested in it as your “main” investment).  If you do decide to keep your money invested, there is an important wrinkle that you need to consider – what to do at the end of the wash sale period.  Any gains that you’ve accumulated in the new fund are going to be short-term capital gains, which are taxed at your ordinary-income tax rates.  you’ll need to either move back to the original fund and eat the tax hit (potentially negating the tax benefits you just generated), or sit in the new investment for a year until any gains are in the long-term category.  The decision will come down to how much better you think the original investment is than the placeholder.

But whatever decision you make, it’s important to recognize that tax-loss harvesting is not the main event.  Your asset allocation is the real driver of your investment returns.  We want to use tax-loss harvesting to augment the returns that your portfolio is generating, but we don’t want to use tax-loss harvesting to drive the portfolio.  You can think of it a bit like a chainsaw.  Incredibly useful in its place, but it’s definitely possible to chop off your foot if you get a little careless.

Tax-loss harvesting can be a real benefit to your portfolio, and something that can have a significant effect when the markets haven’t been kind.  But it’s only part of the broader portfolio management process.  If you’d like to learn more about tax-loss harvesting, and all of the other things you should be doing to keep your portfolio pointed in the right direction, register for my upcoming webinar, Managing Your Portfolio: The 6 Step Process to Maintaining the Portfolio you Designed, on either Tuesday, May 4 or Wednesday, May 5.

16 comments

  1. Thanks for the article; I appreciate the information. It may be useful to me down the road, after I’ve retired and no longer in my company-sponsored 401k program.

    1. Douglas – yeah, if all of your investments are in your 401(k) there’s not much to do in terms of tax loss harvesting. It feels strange saying that I hope you can get some use out of it, since you need to lose some money first, but hopefully it at least helps you make some lemonade in the future.

    2. Great article. I just want to stress the point that “wash sale” applies to all taxable type of investment account. The wash sale is not relevant in retirement accounts as long as the money stays in the retirement account (since there is no taxable event yet).

      1. Absolutely – the wash sale, and tax loss harvesting in general, is only applicable in your taxable portfolio. And unfortunately there is no wash sale rule for gains – the IRS is going to get it’s money.

        1. the wash sale … is only applicable in your taxable portfolio

          Selling for loss in taxable account and buying substantially similar
          in an IRA within 30 days is a wash sale.

          1. You’re right – I wasn’t very clear with that comment. If you buy a substantially similar security in any account that you control it triggers the wash sale rule, and your loss will be disallowed. I was more getting at the wash sale rule only being relevant if you are selling something for a loss in the taxable portfolio.

  2. There are fewer tax loss harvesting opportunities for buy and hold investors of broad index funds. It might be a long time until there is a loss on shares of Vanguard Total Stock Market Index fund (vtsax or vti) purchased several years ago. I wish there was a way to access the “losing” individual stocks held by an index fund.

    1. Dave – it is a tradeoff. If you want more control you need to give up *a lot* of convenience. But in the specific case of Vanguard’s funds you actually get some of the benefits of tax loss harvesting in a roundabout way. Because the fund has both mutual fund and ETF share classes, it can get rid of it’s appreciated holdings and reduce the taxable gains that their investors have to deal with. Not exactly the same thing as harvesting the losses, but it gets you to the same point, and you don’t need to worry about the wash sale rule…

    2. I’m facing the same thing whereas I’ve held on to most all my positions for years and they are all gains (mostly index funds/ETFs), so there are no losses to harvest (even during the big drop last year). I do tax loss harvest in my “play account” where I dabble in individual stocks and do this to offset gains of stock pick winners but the impact of this is pretty small.

  3. Tax loss harvesting is not just for stocks too. I was actually able to take a loss on some Cryptocurrencies that I had sold in January of 2020, for my 2020 taxes.

    But I love your quote here “You can think of it a little bit like a chainsaw. Incredibly useful in its place, but it’s definitely possible to chop your foot off if you get a little careless.” so true. Just gotta take advantage of opportunities IF they arise, but nothing to get too carried away with.

  4. Good write up on tax loss harvesting, thanks for sharing!

    Opportunity cost comes into play as well. You referenced index funds in your examples but suppose you bought shares in XYZ Co. and not long after purchasing them they lost a significant amount of their value (that’s definitely never happened to me /s). You may be tempted to hold onto those shares until they recover, but in the meantime you are missing out on the opportunity for your money to grow (i.e. opportunity cost). So, in some cases, it may be better to harvest the loss, reap an immediate benefit by offsetting gains elsewhere, and put your money to better use by investing it in something that is likely to grow, like a more sensible index fund, rather than waiting (hoping) that the individual stock(s) you purchased will recover any time soon.

  5. Tax Gain Harvesting is another good strategy for those finding themselves in low tax brackets in select years. A lot of people are more familiar with Tax Loss Harvesting but we should also keep the Tax Gain Harvesting option in our back pocket to use when our income dips and we want to harvest some gains at a lower tax bracket!

    1. Good point about taking advantage of Tax Gain Harvesting during low income years, e.g., retired and before social security and RMDs. The lowest LT cap gains rate is 0%. Exploit low income years via Tax Gain Harvesting and/or Roth conversions.

  6. This was huge for me in 2020 when the market dropped. I’ve never taken money out over the past 10 years so I was able to harvest $14,000 worth of losses and then I sold $100,000 worth of stocks which generated $12,000 worth of gains and I paid off my house and still took a $2000 loss on my taxes. Win win!

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