Tax-Loss Harvesting

Can solely right investments build your wealth? 🧐

Building wealth from stock takes a lot more than just making the right investments. The best investors take into account how their portfolio performance affects theim and tax issues.

Unfortunately, nearly every investment will perform poorly at some point. It’s just an inevitable fact about how markets work. No matter how intelligently you invest, there is always the chance that something goes awry.

Market downturns are not all bad; they come with a silver lining. One great thing about America is that investors can count on Uncle Sam to help absorb their losses.

If you suffer losses from a series of bad investments, then you can deduct that loss from your taxable income. The US allows individual investors to deduct up to $3,000 in lost investments to lower their overall tax burden, which is considered by many as an essential tax move. This tax advantage can let you save thousands on your taxable income from investments.

This is a concept known as “tax loss harvesting.” This guide will explain how it works, and how you can claim that deduction.

What is Tax-Loss Harvesting? 💡

At its most basic form, tax-loss harvesting is a method of selling poorly performing securities to lower your overall tax burden. The point of tax-loss harvesting is to minimize the amount of capital gains tax on your portfolio. You might be wondering: does tax-loss harvesting make sense? Well, if you like to pay lower taxes (i.e. everyone), then yes — tax-loss harvesting most certainly makes sense.

In other words, tax-loss harvesting is a useful method to hold on to more of your hard-earned money. You can use capital losses from poorly performing assets to lower the amount of tax you have to pay on capital gains.

The best part of tax-loss harvesting is that you don’t have to be uber-wealthy to take advantage of it. Even a modest portfolio can benefit from harvesting. Investors can sometimes use tax-loss harvesting to offset taxes on their ordinary income.

In the first step, your capital losses are used to offset your gains. The remaining loss can then be deducted as ordinary income.

Tax-loss harvesting only applies to taxable accounts. That means that it will not work for tax-deferred accounts as those kinds of accounts are not subject to capital gains taxes.

The reasoning for this tax deduction is pretty simple. The government wants to stimulate business and investor activity, so they offer potential tax benefits in the case of a loss so that investors are not completely dis-incentivized from investing if some assets perform poorly.

How Does Tax-Loss Harvesting Work? 👔

In order to better understand how tax-loss harvesting works, we need to first talk about how investments are taxed.

The amount that stock increases when you hold onto it is called capital gains. When you sell an asset at a profit, those gains are realized and subject to a capital gains tax. This tax rate differs depending on how long you held on to the investment.

Short-term capital gains apply when you owned the security for less than a year. Short-term gains are taxed as ordinary income with the highest current bracket of investors maxing out at 39.6%.

Investments held for longer than a year are taxed as long-term capital gains. As of 2020, the long term capital gains tax was 0%, 15%, and 20%, depending on income.

Here is a simple example of how this works. Say you have 100 shares of some energy stock that was valued at $100 a share.

After 6 months, the value of the individual shares rises to $150 per share. You sell all 100 shares and net a tidy $5000. Since you held onto that stock for less than a year it is taxed as short term capital gains.

Assuming you fall in the 24% tax bracket, you would have to pay (0.24 ✕ 5,000) = $1200. After taxes, you would have profited $3,800.

If you had held on to that stock for more than a year and then sold it for the same value, the profit would have been subjected to long term capital gains taxes. At the same income level, you would only have to pay 15% in long term capital gains taxes. That comes out to (0.15 ✕ 5,000) = $750.

Here is Where Tax-Loss Harvesting Comes In 💨

Say you also have some hospitality sector stock that is doing poorly. You bought 100 shares for $50 each and over time the share price has fallen to $40 per share, which is a $5,000 – $3,500 = $1,000 loss.

You can take that loss and deduct it from your total capital gains so you would only have to pay taxes on $4,000 of the gains you made from selling your energy stock. In the 24% tax bracket, that would come out to (0.24 ✕ 4,000) = $960 paid in short term capital gains and (0.15 ✕ 4,000) = $600 in long term capital gains.

If your losses completely offset your gains, then that leftover amount can be used to offset your taxable income. The IRS allows up to $3,000 of your income to be offset from capital losses. If you have more losses, that amount can be carried forward to lower your future tax burden in the following years.

This is the main strategy of tax-loss harvesting. You “harvest” poorly performing investments and use those losses to offset the total amount of capital gains taxes you have to pay. In some cases, you can even eliminate having to pay taxes on investment gains and deduct taxes from your ordinary income.

Is Tax-Loss Harvesting a Good Idea? 🧠

You might be wondering what the point of all this tax-loss harvesting business is. Here is where it gets fun. Remember those poorly performing hospitality stocks you sold at a loss? You can take those funds from that sale and purchase a similar asset that you believe will do well in the coming future.

Buying this similar stock is a way to avoid securing an actual loss because those funds are immediately invested into some other similar security. The idea is that you can maintain more or less the same portfolio performance while getting a nice tax break in the meantime.

Again you might be wondering, what’s the point — how is tax-loss harvesting a good idea? You’ll just have to pay taxes on those new capital gains later down the road right? This is true, however, we would say you are in a better off position than you would be otherwise.

First off, you deferred your taxes until later, while also getting a nice interest-free loan from the government. Moreover, tax-loss harvesting can serve to rebalance your portfolio to distribute risk across your assets. You can also use strategic tax-loss harvesting to drop to a lower income bracket so you get a lower tax rate.

IRS and the Wash-Sale Rule 📜

As you’d probably expect, the IRS is not too fond of people trying to take advantage of tax-loss harvesting to significantly decrease their tax burden. The wash-sale rule is their attempt to prevent people from abusing the tax-loss system by preventing the purchase of identical or similar funds with the proceeds you generate from a loss sale.

According to the wash-sale rule, when an investor sells a security at a loss, they are not allowed to purchase “substantially identical” shares within 30 days of the sale or 30 days after the sale is completed. If the investor tries to report the loss as a deduction, the IRS will not allow it and you won’t receive any tax advantages from the sale.

The wash-sale rule also applies if an investor’s spouse or a company controlled by the investors buys substantial identical shares.

Like we said earlier, the wash-sale rule is the IRS’s attempt to crack down on tax-loss harvesting by preventing investors from claiming artificial losses. If an investor buys substantially identical shares within the 61-day time-frame then the proceeds can not be used to lower your capital gains tax liability.

The wash sale rule does not only apply to individual stock either. Options contracts (which are traded like stock) are subject to the rule. If an investor buys a substantially identical options contract in the 61-day time-frame, then the transaction falls under the wash-sale rule.

What Does “Substantially Identical” Mean? 💭

The wash-sale rule covers the purchase of “substantially identical” shares, but what exactly does this mean? Essentially, substantially identical securities are not considered separate investments by the IRS.

Shares from the same company are considered substantially identical to one another while shares from different companies are not. Typically, preferred stock and common stock of a single company are not considered substantially identical unless the preferred stock can be converted to common stock without qualification.

Otherwise, substantially identical normally means that the shares’ market and conversion prices are the same. This definition is explicitly made to target the kind of securities that are used for tax-loss harvesting. If two shares are deemed substantially identical, then it’s considered a wash sale and the tax benefits from the transaction would not be allowed.

Getting Around the Wash-Sale Rule 🤔

The wash-sale rule applies to all taxable brokerage accounts and IRAs. There are methods to get around the wash-sale rule and maximize offset losses.

One way is pretty complicated and involves multiple transactions. Essentially, you can mix selling securities and buying options contracts to trigger the wash-sale rule and then immediately override it with another transaction. This method can be fairly complex and is best left to computers that can automate the transactions.

Another option involves utilizing exchange-traded funds. ETFs consist of a wide range of securities and are usually tracked according to some exchange index, such as the S&P 500. Since ETFs encompass many different classes of investments, you can sell poorly performing ETF shares and purchase different ones in the same index without triggering a wash-sale.

So for example, say you are invested in the Vanguard S&P 500 ETF and you experience a loss. You can sell off those shares and immediately buy back into the State Street SPDR S&P 500 ETF without it being considered a wash sale.

The reasoning behind exempting ETF purchases from the wash-sale rule is that 2 ETFs have different managers and likely have different expense ratios, use different methodologies to allocate investments, and have different levels of liquidity.

The IRS does not presently count these kinds of transactions as wash-sales with substantially identical assets, but there is the possibility they may change the rules as the practice becomes more common among investors.

How Much Can Tax-Loss Harvesting Save Me?

How much you can actually save through tax-loss harvesting depends mostly upon your income tax bracket and the character of the asset you are trying to offset.

We have already talked about the difference between short-term capital gains and long-term capital gains. The optimal way to utilize tax-loss harvesting involves offsetting short-term gains with short term losses and long-term gains with long-term losses.

Given that long-term gains are taxed lower than short-term gains, the best way to reduce your liability is to offset your long term losses with long term losses. The same is true for short-term gains and short-term losses.

You do not have to do it this way though. If you gain a profit in one and a loss in the other, you can still offset your gains. Remember that up to $3,000 of the remaining amount can be carried over to your ordinary income and any more can be carried over to the next tax season.

Strategic use of this tax deferral mechanism can be a good way to soften your initial tax burden if you jump up an income bracket in the coming year or decrease your tax liability even more if you expect to drop an income tax bracket.

Let’s Crunch Some Numbers as an Example 🔢

Say you incur a $35,000 loss and a $30,000 gain. In that case, your capital losses would completely offset your capital gains. Moreover, $3,000 of the $5,000 remainder can be deducted from your ordinary income tax.

Putting all those numbers together and assuming you are in the 35% tax bracket, you would save:

($30,000 + $3,000) ✕ 0.35 = $11,550

Using a tax-loss harvesting strategy, you could stand to shave over $10k off your tax liability.

How Can I Do Tax-Loss Harvesting? 🧮

If you are good with numbers then you could probably pull off a substantial amount of tax loss harvesting on your own. Luckily for those of us not so good at math, computers can help out and make the process much easier. Computer-aided transactions are the go-to choice for tax-loss harvesting as it’s less likely they will fudge a transaction and trigger a wash sale.

Several robo advisors like Betterment, Wealthfront, and Vanguard offer automatic tax-loss harvesting on client accounts. Algorithms automatically crunch the gains offset and the optimal time to buy and sell as to not run afoul the wash sale rule. Performing tax-loss calculations by hand and making each transaction deliberately takes a lot of time and effort.

Robo advisors streamline the process by doing all the tough calculations for you, including rebalancing your portfolio.

Robo advising services usually perform tax-loss harvesting services using ETF investments. Hardcoded protocols and algorithms literally prevent robo advisors from purchasing identical securities once they sell them at a loss.

If you don’t choose to use a robo advisor, then the next best suggestion is to get the help of a professional financial advisor.

Pros and Cons of Tax-Loss Harvesting ☯️

Tax-loss harvesting is a viable strategy to lower your overall tax liability on capital gains, but it has its own risks and downsides. Chief among them is that tax-loss harvesting does not eliminate taxes on capital gains, but only defers them to a later time.

If you sell shares at a $7,000 loss and use those proceeds to buy other shares, you will still have to eventually pay capital gains taxes on that reinvested amount. You just won’t have to do it right away and you can hold onto your money for a bit longer.

Tax-Loss Harvesting Pros 📈

With all of the following benefits, we absolutely say tax-loss harvesting is a good idea:

Can Substantially Lower or Eliminate Tax Liabilities on Capital Gains 🤲

The single biggest benefit of tax-loss harvesting is that it lowers your overall tax liability on capital gains. If the amount of losses you incur is greater than your gains, then your losses could completely offset your gains and you would not have to pay any taxes on that income.

What’s more, if you have a remainder amount after offsetting your gains, the IRS will let you deduct the remaining amount up to $3,000 off your income tax. That $3,000 deduction alone comes out to about $1,000 in cold hard cash that gets knocked off your taxes.

Good in the Long Run 🛣

Tax-loss harvesting is good for investors in the long-term as they can get the tax benefit from offsetting gains with losses and buy back shares before the market bounces back.

Good for Re-Balancing Portfolio 👤

Smart investors use tax-loss harvesting as a tax opportunity to re-balance their portfolio or change allocation ratios. Tax-loss harvesting is a good way to prune your portfolio of unfruitful investments and dispose of unwanted shares.

The Process Can Be Automated and Secure 🛡️

Given that several brokers offer automatic tax-loss harvesting for free, it would be pretty daft to not take advantage of it. When it comes to stock taxes, many agree there’s no better tool than automated tax-loss harvesting.

Automated investment systems know how to calculate which stocks are optimal to shed and have fail-safes to prevent initiating a wash transaction. Automated robo advisors are often much cheaper than traditional financial advisors.

Potential to Improve Returns 💰

There is also evidence that proper tax-loss harvesting can actually improve overall portfolio performance. The exact percentage improvement is hard to pin down due to varying methodologies for calculating the figure, but according to Wealthfront, an investor using their tax-harvesting services could have had a 155% increase in after-tax portfolio performance. That means you could have increased a 6% performance to 7.5% which is a big deal.

Think of that this way. If you invested $100,000 at a 6% return, after 20 years it would be worth about $333,000.

Now imagine you invested that same $100,000 at 7.5 for 20 years. That would give you over $400,000 in returns. That’s a difference of over $70,000, and that’s assuming you never invest any more money.

Cons of Tax-Loss Harvesting 📉

Despite the benefits, there are still a number of tax-loss harvesting pitfalls:

Complicated Process 💸

If you haven’t noticed already, taxes are ridiculously complicated (some would say intentionally so!). Navigating tax law while tax-loss harvesting is difficult and confusing.

If you have multiple investments spread across multiple accounts you want to get rid of, calculating the appropriate tax losses will be hard. There is also more chance that you will initiate a wash-sale and lose that tax benefit. Once again, that is why several brokerage and robo-advisors offer automated tax-loss harvesting.

Wash-Sale Rule Puts Limitations on Tax-Loss Harvesting

Unfortunately, that pesky wash-sale rule put some limits on how much tax-loss harvesting you can get done. The IRS requires you to offset gains with the same kind of losses.

That means you have to offset long-term gains with long-term losses and short term gains with short term losses. The only time you can apply losses of one kind to gains of the other kind is if you have more losses than gains in total.

Potentially Higher Tax Bill in the Future 🔮

A handful of experts argue that regular tax-loss harvesting during the year can ultimately cause greater capital gains taxes to be paid in the future. The idea is that reinvesting funds secured from a loss sale drives your cost basis lower.

If the new investment does particularly well, you might have to pay more capital gains taxes in the future. Of course, there is always the possibility that the government will raise capital gains tax rates.

The upshot of this kind of scenario is that the tax benefits you get from selling at a loss can carry over to offset taxes in the future. In general, it’s a better idea to save money on taxes now, regardless of the amount to be paid in the future. This is because the present value of $1,000 is always greater than $1,000 later down the road.

Tax Deferral Might Not Always Be a Good Idea 💵

The main benefit of tax-loss harvesting is that it defers taxation on investment gains. Tax deferral can be especially beneficial if you think that you will be in a lower tax bracket later down the road. Also, if tax rates get lowered in later years, even better.

However, there is always a chance that tax rates will be higher in the future. This could happen because the government raises taxes or you might be in a higher income bracket when you retire.

Transaction Fees 🏦

Tax-loss harvesting is a complex process and involves making several financial transactions. If your broker charges for each financial transaction, those commission fees can add up pretty quickly. If loss harvesting transactions are made too frequently, it can greatly lower the overall value of your portfolio.

Only Works with Some Accounts 👥

Tax-loss harvesting only works with taxable brokerage accounts. That means accounts like IRAs are not eligible for loss deductions on your taxes.

Conclusion 🏁

Nobody likes paying taxes so why pay more now when you could invest that money for more later? Tax-loss harvesting is an efficient way to shed unwanted assets and is a convenient method for rebalancing portfolios and lowering your overall tax burden.

The best part is that tax-loss harvesting is not just for the high rollers. You don’t have to be a high net-worth individual to take advantage of it. If you take a particular loss on some investment, tax-loss harvesting can minimize the financial losses by giving you tax savings.

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