DR Podcast 301: A Guide to Tax Loss Harvesting

Tax loss harvesting can be a smart tool for investors. But first, you have to learn how it works. Here’s our easy guide to tax loss harvesting.

Even in a period of economic prosperity, not every investment pays off, and there are bound to be losses. Fortunately, as the saying goes, every cloud has a silver lining and so does every investment.

You may be able to turn your investment losses into tax gains, reducing the impact on your financial health. This concept is known as tax loss harvesting.

Tax loss harvesting is one of the few free lunches in the world of investing. With a little planning, you can reduce or even eliminate your capital gains in any given year. In some cases, you may also get a deduction from ordinary income of up to $3,000.

Note from the editor: In this episode of the podcast, Rob tells us about tax loss harvesting, sometimes abbreviated TLH. Learn how it works, its benefits, its limitations, and how you can use it to defer taxes. We’ll also look at the implications for those who use robo advisors that offer TLH services. If you prefer to read rather than listen, we delve into tax loss harvesting below, so read on.

What Is Tax Loss Harvesting?

Briefly, tax loss harvesting is the selling of securities at a loss to counteract a capital gains tax liability.

Capital gains are the additional money an investor receives after the sale of security above its original purchase price. A capital loss is the difference between the selling price and purchase price of a security sold for a loss.

Whenever you make capital gains, the profit is taxable. But if you take a loss on an investment, those losses can be offset against any profit netted from capital gains. The result is you can reduce or eliminate your income tax liability on the capital gains.

A Practical Example

You’re an investor, and after a review of your portfolio, you notice your stocks in the tech industry have risen sharply while your stocks in the energy sector have declined in value.

You realize you want to cash in on the rise of your tech stocks and reduce your exposure in anticipation of a market swing. You sell off some of your tech stocks, and now you have a capital gain and a tax liability due on that gain.

This is where tax loss harvesting comes in handy. If you sell the energy stock in your portfolio that has fallen in value, you can use the loss to reduce the tax you owe on your tech sector gains. This reduces your tax liability.

If the losses you incurred on your energy stocks are greater than the gains you made, the residual amount can offset $3,000 of your taxable income. This is the cap the IRS has set. And if you still have any additional loss left, that amount can be carried forward to offset losses in the subsequent years.

For example, the sale of your tech stocks netted you a gain of $20,000, and you purchased that stock less than a year ago. The time of the purchase is important because short term capital gains (held for less than a year) are taxed at a rate higher than long term capital gains (held for over a year).

The sale of your energy stocks netted a loss of $25,000. Tax loss harvesting would imply that the $25,000 loss would cover the $20,000 gain you made and the remaining amount of $5,000 would offset $3,000 from your ordinary income. The remaining amount of $2,000 is carried forward to subsequent years and can reduce tax liability on capital gains.

How Tax Loss Harvesting Works

Here are a few applications of how tax loss works in your favor.

Strategically Offset Losses Against Gains

In the previous example you sold off two investments, the profitable tech stocks and the loss incurring energy stocks, and paid no taxes. However, there is no rule to sell both investments to utilize the benefit of tax loss harvesting.

The IRS allows individuals to carry forward their losses indefinitely to be utilized at the investor’s discretion. Instead of selling off both positions you could retain your funds and cash them in at a more opportune moment.

How Much Tax Loss Harvesting Can Save You

The money you’re trying to save in taxes through tax loss harvesting mainly depends on two factors; your applicable tax rate and the nature of the revenue stream you’re trying to offset.

The IRS taxes the income realized from capital gains, but the rates vary depending on the period the investment was held by you.

Since short terms gains are taxed higher than long term gains, it makes more sense to offset short term gains against short term losses. It also holds for long term capital gains and using them to offset long term losses.

If, however, you incur a loss in one and a profit in another, tax loss harvesting can still offset the loss. Any remaining amount is carried forward to reduce the taxable income outside the scope of investment revenues.

Taking the first example of tech stocks and energy stocks, let us look through the number you stand to gain from tax loss harvesting.

Let’s assume you fall in the 35% tax bracket. So, $20,000 was your capital gain offset with a further $3,000 deducted from your ordinary income.

($20,000 + $3,000) * 35% = $8,050

You stand to save $8,050 in total savings from utilizing tax loss harvesting.

Things to Keep in Mind With Tax Loss Harvesting

The critical aspect to remember for a successful implementation of tax loss harvesting strategy is to assess what you own and why you own it, identify investments running a loss and then to discard a portion of those investments against capital gains, expected capital gains or even your income.

Keep Reinvesting But be Wary of Wash Sales

After deciding the investments you want to dispose of and offset the loss through tax loss harvesting, you must decide upon reinvestments. But you must be careful of a rule which applies on tax loss harvesting called Wash Sale Rule.

Suppose you invest in the same type of stock you sold to realize a loss. You believe the value will rise or that it matches your desired diversification and risk tolerance. The Wash Sale Rule states that your tax loss harvesting claim will be declared void if you buy back the stock or a contract to buy the stock within 30 days before or after the disposal of the relevant stock.

If you want to keep exposure of the industry in your portfolio, one way to go around the Wash Sale Rule would be to buy stock in a similar company that operates in the same industry and has more or less the same amount of market share. Or you could purchase an exchange-traded fund (ETF) that tracks the relevant sector.

Although some substitutions are allowed and don’t violate the Wash Sale Rule, others can still lead to a void claim. This happens when the IRS deems the substitute as substantially identical to the disposed of investment. Consult a tax advisor if you’re unsure before making a reinvestment.

Wash Sale Rule & IRA Accounts

The Wash Sale Rule applies to purchases inside an IRA. If you sell an investment to create a loss in a taxable account and then buy the same or substantially identical investment in an IRA account within the 30-day window,  the Wash Sale Rule will wipeout the tax loss.

Here’s the deal–

  • Section 1091 of the Internal Revenue Code creates the Wash Sale Rule;
  • It says NOTHING about IRA or 401k accounts;
  • In 2008, the IRS issued Revenue Ruling 2008-5, concluding that the Wash Sale Rule applies if a loss generating investment is replaced in an IRA;
  • The ruling says nothing about 401(k) accounts, but the Wash Sale Rule likely applies to purchase in these accounts, too.

You can refer to IRS Pub 550, Investment Income and Expenses (Including Capital Gains and Losses) for more details.

As an Investing Strategy

The best way to maximize the impact of a tax loss harvesting strategy is to integrate it into your annual tax saving and investing strategy.

Tax loss harvesting and portfolio diversification go hand in hand. That’s because if you believe that security will not pick up in value in the future and is incurring a loss right now. You could see the security and invest in an industry or company that adds to the diversity of your portfolio.

Portfolio rebalancing and tax loss harvesting are also a natural fit. A rebalancing of the portfolio occasionally is an excellent method to assess investments in loss and could prove ideal candidates for tax loss harvesting.

Don’t Sell Off Simply for the Sake of Realizing a Loss

Investors should remember not to let the tax tail wag the investment dog.

If you have stocks or securities in your portfolio performing below par, don’t sell them off immediately to realize a tax loss. Often market swings are fueled by speculation and not economic or financial facts.

That doesn’t mean you keep sitting on a loss-incurring investment hoping for it to increase in value. There’s a thin line between a smart sale and selling due to market pressures to realize a tax loss.

Pros and Cons of Tax Loss Harvesting

Tax loss harvesting is one of the most popular options amongst investors to maximize after-tax returns. But many individuals don’t know this strategy comes with its own risks.

There’s always the lurking risk of selling a stock just about to pick up or is temporarily down due to market speculation. There is also the fact that market analysts believe that the overall effect of selling investments and re-purchasing them again is just a tax deferral and not a gain.

Conventional investors also hold tax loss harvesting in contempt because it goes against the fundamentals of investing which state to buy low and sell high. Selling important stocks pivotal for diversification to save a few dollars on taxes is a hard note for many investment veterans to swallow.

Below, I summarize the pros and cons of tax loss harvesting.

Pros

  • Can reduce or altogether eliminate tax liabilities on capital gains realized.
  • This strategy is optimal for investors aiming for the long term as they can buy back shares at a lower price before the market corrects itself.
  • It is a good strategy for portfolio rebalancing as it makes disposal of unwanted loss incurring shares easier.
  • Robo advisors can execute this strategy as many of the robo adviser brokerages offer this feature and are much cheaper relative to a traditional financial advisor.

Cons

  • If you have multiple investments, you wish to dispose of, calculating the gains from a tax loss harvesting strategy can be complicated.
  • There is a lost opportunity if the gains are not reinvested properly.
  • Requires adequate planning and usually the aid of a software application or financial advisor, though the associated costs of these options might not leave you with any gains even.
  • Wash Sale Rule puts restrictions till the cool down time is over.

Online Robo Advisors that Offer Tax Loss Harvesting

Robo advisors add another dimension to TLH. Services such as Betterment and Wealthfront have promoted their automated investment services with the help of tax loss harvesting. They promise to increase your effective returns by harvesting losses on a daily basis. The promised benefits exceed the cost of their services, which I recently compared.

Related: Top Robo Advisors

However, recall that purchases inside a retirement account can trigger the wash sale rule. Recall also that robo advisors buy and sell investments inside your account automatically to generate tax losses. Combined, these can cause a real headache.

For example, imagine you use one robo advisor for your taxable account, but have retirement accounts at other firms. This would be common, for example, if you have a 401(k) through your employer, use multiple robo advisors, have separate brokerage accounts, or use accounts at a mutual fund company like Vanguard for IRAs.

Here’s the problem. The robo advisor will sell investments in your taxable account to generate tax losses. These sales can happen daily, and certainly monthly. Within 30 days of these sales, if you purchase the same or substantially identical investment in one of your retirement accounts, you’ll trigger the wash sale rule.

If all of your accounts are with the same robo advisor, they use software to prevent this from happening. If they are not at the same firm, however, great care should be used before activating the TLH service.

With all of that being said, several factors go into an effective tax loss harvesting strategy. These elements include keeping a record of the costs basis of each investment, getting the sale time right and awareness of your tax bracket.

You could manage all the elements, but things get complicated if you have multiple investments.

Most online robo advisors offer tax loss harvesting as part of their services. Some of the best ones include:

M1 Finance

One of the top online brokerages, M1 Finance has some of the lowest fees in the industry as it charges no management or commission fee. Though the company doesn’t offer tax loss harvesting, it does offer tax minimization that helps to reduce taxes when selling a security.

Betterment

Betterment provides investors the perfect strategy by automating asset allocation on the platform’s tax coordinated portfolios. The strategy deployed by Betterment can increase tax returns by 15% over thirty years.

The company utilizes tested algorithms on its Tax Loss Harvesting Feature+ feature for daily assessments of tax loss harvesting opportunity.

Wealthfront

The company estimates that its tax-efficient portfolios and bond diversification can net an after-tax return of 0.5% per year. The company offers tax loss harvesting as a free service to customers using the platform.

Wealthfront assesses tax loss harvesting opportunity daily. It identifies loss-incurring ETFs and purchases alternative ones as a replacement. You can override the company’s buy and sell decisions if you don’t want to utilize the tax loss harvesting feature for specific ETFs or stocks.

Related: Wealthfront Review

Wealthsimple

Wealthsimple offers people the chance to invest in a diversified portfolio and allows financially sound investors to observe how their investments are being made.

Tax loss harvesting is available to all Wealthsimple Black customers. The option can be turned on from the settings menu, but the company highly recommends that not all investors should utilize this option and that it is not meant for passive investors.

Personal Capital Wealth Management

Personal Capital Wealth Management is a registered investment advisor (RIA) which means they are bound by the law to act in the best interest of their clients. The firm offers timely rebalancing and tax minimization including tax loss harvesting feature.

Related: Personal Capital vs. Betterment Comparison

Bottom Line

Not everyone can invest like Warren Buffett, and the rest of us need a cushion to prevent us from free-falling into an oblivion-like loss. If that cushion is helping us minimize the financial impact of losses through tax savings, then it is better than having no fallback option. However, tax loss harvesting is a reactive strategy, not a proactive one.

Additional Resources:

Topics: InvestingPodcastTaxes

3 Responses to “DR Podcast 301: A Guide to Tax Loss Harvesting”

  1. Nice podcast about TLH. But, have you ever heard of TGH (Tax Gain Harvesting)? I took advantage of TGH for many years after I (early) retired from Apple. I had tons of shares of AAPL at employee discount prices. Prices ranged from $5-$25. Over the next 8-10 years after I retired I sold hundreds of shares of AAPL and then bought them back the next day (there is no wash sale period if you sell at a gain). The purpose for doing this exercise was to raise my cost basis. The reason why this worked (for me in my particular tax situation) was because I was below the 15% tax bracket, qualifying me for zero percent long term capital gains. So I just ‘filled-up’ my tax bracket with long term cap gains by selling as many AAPL shares as I could without exceeding my 15% tax bracket. I eventually raised the cost basis of all my AAPL shares to either $55 or $73. Now someday down the road when I want to sell some of my AAPL shares, but I’m in a higher tax bracket due to RMD and (finally) collecting Social Security, my cost basis on those AAPL shares will save me quite a bit on cap gain taxes. 8^)

    — jcw3rd

  2. It’s there an easy way to track your carried forward tlh from year to year? Last year I sold international index (VTIAX) for a loss of $9,000.. so i have 3 years of tlh to carry forward (no realized capital gains).. but sorry if remembering how much to carry forward each year, is there something to help with that?

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