Who wants to lose money in the stock market? All I can hear are crickets.
But it does happen to everyone at some point in their investing careers. It can happen many times actually. And that is where tax loss harvesting comes into play.
I like the definition provided by Betterment, where they say and I paraphrase that it’s a way to sell a security that has experienced a loss and in the process pay lesser taxes on the sale of securities that have experienced gains. In other words:
If security is experiencing a loss, then sell and pay less tax from securities that have gained.
With the proceeds of a sale, buy a similar security.
Tax Loss Harvesting Example
So let’s illustrate with a simple example:
I buy Vanguard Total Stock Market Fund – VTI for $120 per share – 15 shares totaling $1,800
VTI is not doing well so I decide to suck it up and I sell all 15 VTI shares at a loss of $110 per share totaling $1,650
Loss = $150
After 30 days (I’ll explain why later), I decide to buy VTI again at $105 per share for 15 shares totaling buy a different total stock market fund for an investment amount of $1,575.
Now if I don’t want to wait until after 30 days, I can buy a different ETF or index fund immediately after selling VTI.
When I file my taxes, I can claim the $150 loss and that will offset ordinary income. I will continue to be invested in the same allocation in my portfolio via my total stock market fund investment of $1,575.
If you’re engaging in tax loss harvesting properly you’ll want to buy a similar security in the same industry so that you are still invested in the same allocation as you originally designed. But as a result, you have taken a loss and can net it against capital gains if applicable, or not then net income.
Be Careful of the Wash Sale Rule
So here is the 30-day rule thing I was talking about earlier. The IRS says that you cannot buy substantially identical” security within 30 days, before or after the sale of your security for which you incurred a loss. So the window where you have the potential to engage in a wash sale is 61 days. This applies to pre and post-tax accounts. This is called the wash sale rule.
For example, let’s say you bought Amazon for 10 shares of Amazon for $1,000 totaling a $10,000 investment. You sell the shares for $9,000. Within 30 days decide to buy 10 shares of AMZN again for a new basis of $8,500. Guess what, you bought substantially identical stock, and can’t deduct the 1,000 loss from your sale of AMZN. Instead, you must add this $1,000 to your second purchase of AMZN at $8,500 and your new basis is now $9,500. The IRS is cool with you when collecting on a gain, but not claiming a loss when you try to sneak in and buy at a lower price.
I’ve read that passive index funds and ETFs that track the same index may fall under the wash sale rule. Since the IRS does not clearly define “substantially identical”, I’d stay away from repurchasing these as replacements as well; at least until the 61-day window has expired.
In addition, the wash sale rule applies to your spouse, a corporation you may own, and substantially similar contracts and options.
How Can Tax Loss Harvesting Work For Me?
It may ease the pain of a loss a little bit by reducing your taxable income. Most people say to take it anytime the market is significantly down and not necessarily wait until the end of the year. What if you have a holding that is down 10% and decide to wait until the end of the year when it is down only 7%. So you have then forgone the extra tax loss you can take and thus deduction on your taxes.
It can also work if your capital gains are taxed at 0% and so you can carry forward a capital loss to the following year when you are taxed for capital gains and as a result can use the loss offset for tax savings.
How to Optimize Tax Loss Harvesting
It can optimize in the short-term, but in the long-term you may pay more taxes. For example, if you sell a stock of ETF that’s down $2,000, you can offset this entire $2,000 to ordinary income and if you’re in the 25% tax bracket, then you have saved $500 in taxes. But at the same time, you’re taking a risk in which the investment that is down by $2,000 won’t rise back up again and may continue to fall.
So with the $500 in tax savings mentioned above, let’s say you sold an investment resulting in a realized gain of $10,000 (long-term capital gain). For a 25% tax bracket, the long-term capital gains tax rate is 15% so the tax for this gain would be $10,000 X 15% = $1,500. But when you apply the $500 in tax savings, you’ll then effectively owe only $1,000 on your taxes.
It’s important to understand that tax-loss harvesting decreases your cost basis only, but the market value stays the same because you’re replacing your underperforming security with a similar security you’ve purchased for less. And as a result, when you eventually and hopefully realize a larger gain from the replacement security in future years, guess what, you’ll have to pay the tax on that gain.
Despite the overall positive performance in the stock market, there are some securities that have experienced a loss in the past year. If you unfortunately hold one of them and are considering selling and buying something else that is not similar right away, you may be able to benefit from tax-loss harvesting. You are still invested in the overall market and have bought in at a lower price. And you can still be diversified in the same manner if you buy a stock in the same sector.
Remember that you can only claim $3,000 of the loss against your taxable income. So if you have a loss of $7,000, it will take you three years to claim the entire loss on your taxes against ordinary income.
For me, tax-loss harvesting is to benefit in the short-term by reducing taxes and thus having some money available to invest. Eventually if you are interested in long-term gains, those taxes will have to be paid at some point. So it is a bit of a double-edge sword 🙂
And lastly, please be aware that I am not a tax professional and you should consult with a tax-professional to see if tax-loss harvesting may be a beneficial strategy for your portfolio.
So readers have you or are you planning to use tax-loss harvesting this year? Do you check up on investment losses throughout the year or only towards the end of the year?
I use Personal Capital because (1) it’s free, (2) it tracks all of my accounts and overall net worth, (3) my account balances automatically update, (4) it shows how my investments are diversified and allocated in various sectors, and (5) can use built-in tools like “Investment Checkup” to get….wait for it…free personalized advice!