You might have heard of a concept called Tax-Loss Harvesting but like most people are hazy on the details. Maybe it’s a new concept altogether. Perhaps you know about it but don’t fully understand why it works or how to quantify the benefits. It’s a powerful tool and we’ll dive in together.
When we invest money, we do so with the hope that our portfolios will appreciate over time. Throughout modern financial history, well-diversified portfolios have typically increased in value, especially when investors maintain a long-term perspective.
However, investment journeys are rarely smooth. Even portfolios designed for growth experience periodic downturns and temporary value reductions. Interestingly, these market fluctuations can create an opportunity to use a clever tool known as tax-loss harvesting – a technique that transforms investment losses into potential tax advantages.
In this piece, we’ll explore tax-loss harvesting comprehensively: how it works, when it makes sense, which investors might benefit most, and importantly, when it might not be an optimal strategy. We’ll also highlight potential pitfalls to help you navigate this nuanced tax optimization approach.
First, some context: How are investments generally taxed?
Before we get to the specific tool called tax-loss harvesting, we’ll start with some key context about how investments are taxed.
Let’s start with an example:
- You live in the US, buy 10 shares of Shmostco stock at $200/share, you now have $2,000 worth of Shmostco stock.
- 18 months pass, Shmostco goes up to $250/share, your shares are now worth $2,500.
Your investment has “gained” $500 in value.
If you received a paycheck of $500 for work you performed, you would have to pay taxes. However, taxation on investments and their gains isn’t quite so cut and dry.
In this example, you don’t owe anything because you haven’t sold the shares, and in the US, you won’t owe taxes on the $500 gain as long as you continue to hold onto the shares.
When you sell your shares, you’ll owe capital gains taxes on the $500 in gains. These are similar to income taxes but are usually a lower percentage. If you held the investment for less than a year you’d generally pay a higher rate assessed on short-term capital gains. If you’ve held the investment for longer than a year, you’d usually pay a lower rate assessed on long-term capital gains.
Generally, if you have an investment gain, holding the shares until you actually need the money is often prudent since most people aren’t in a hurry to pay taxes. So, people invest for long-term goals like retirement and plan to hold those investments for a number of years–putting off the tax burden on any gains they have until a later date.
But, what if you have a net loss on your investments?
It’s not something most people like to think about, but there are some benefits to having your shares lose value.
Someone who has an investment that is at a loss and wants a tax benefit is in a situation where they can use tax-loss harvesting (TLH).
The mechanics are simple: when an investment position is at a loss, you sell it and then enjoy the extra tax deduction you have generated.
Here is an example:
- You buy 10 shares of Schmapple at $200/share for a total of $2,000.
- 18 months pass, and it has been stable, but all of a sudden, Schmapple goes down to $150/share, and your shares are now worth only $1,500.
Unfortunately, your shares are now worth $500 less than you bought them for.
If you sell them, you’ll generate a $500 tax deduction and might save about $200 on your taxes.*
Then, you can wait 30 days and repurchase Schmapple shares if you so choose–that way if it goes up again in the future, you’ll get the benefit. If you buy it and it goes up, you’ll be happy. If it goes down again, you can do another round of tax loss harvesting and generate more tax savings. You can also use the $1,500 you freed up to invest in a competitor or in a diversified group of investments.
Why do I wait 30 days to repurchase my investment?
The IRS’s wash rule penalizes people who sell a security and then buy a substantially identical security within 30 days. The specifics of this rule can be complicated, especially in determining precisely what “substantially identical” means. If you sell Schmapple and buy it right back the next day, your tax loss harvesting benefit will likely be disallowed since it isn’t just “substantially identical;” it is “the same thing.”
A simple approach is to wait 30+ days and repurchase the same security. But if the price increases, you’ll get a somewhat less good deal when you repurchase it. Your tax benefit may more than offset that problem, but you’d still like to avoid missing out on gains.
A common approach is to buy something quite similar but not so similar that it is “substantially identical.” For instance, if you sell Schmapple and buy Toyota, you’re playing by the rules, since they are two totally different companies doing totally different things. If you sell Schmapple and then rebuy Schmapple the next day, that’s a clear problem since it’s the *same* security. But there are cases that are less clear.
Presently, the IRS doesn’t seem to object to switching to a different S+P 500 fund with different tax characteristics, different managers, different expense ratios, and sampling methodology. Unfortunately, the IRS doesn’t publish a precise set of criteria so there is some uncertainty about where the line is if you get more similar than the last example.
Exactly how can I benefit from tax loss harvesting?
When you tax-loss harvest, you create a tax benefit. That benefit generally helps when you file your taxes.
Depending on the circumstances, tax loss harvesting can:
- reduce taxable capital gains
- reduce taxable ordinary income
- pass on to the next year
Long-term losses (if you held the position for more than a year) first apply to long-term gains (such as selling a different position for a profit).
If you still have some losses left over after you have offset all your gains, you can take up to $3,000 per year against ordinary income (like wages or consulting income). This is especially advantageous because ordinary income is generally taxed at a higher rate, so this deduction is more valuable since it saves you more in taxes.
For example, let’s say you bought Shmosco and Schmapple as above. Shmosco gained $500, you sold it and kept the profit, and you also bought Schmapple. It went down $500, you tax-loss harvested it, then repurchased it, and it went up.
In that situation, you made $500 on the Shmosco stock, but you don’t have to pay any taxes since your tax-loss harvest offset them.
If you managed to generate a TLH at Schmapple but had no gains to offset it against, you could just use it to reduce your taxable ordinary income – which could be even more advantageous from a savings perspective.
Do I keep my tax benefit even if the investment goes up later?
Let’s start with an example again:
- You buy 10 shares of Schmapple at $200 (total of $2000).
- It goes down to $150/share.
- You tax-loss harvest (realizing a tax benefit of $500).
- Schmapple stays level at $150.
- 31 days later, you buy 10 shares for $1,500 (conveniently, it didn’t change in price during those 30 days).
- Over the next few years, Schmapple goes up to $250.
In this example, your investment in Schmapple has made you several hundred dollars and you *also* have a tax benefit from the period when it went down.
Even though you have a gain, you also have the benefit of a loss. Even though you don’t actually have a loss anymore because you reinvested in shares that aligned with your portfolio goals. Cool, right?
Is this just free money?
Using the same assumptions as before*, your $500 tax-loss harvest would save you $200 on their taxes for being clever (or having an advisor who pays close attention and understands this technique).
But wait, it’s not that simple.
When you create a benefit from tax-loss harvesting, you also create a tax liability.
When you sell a stock, you generally only have to pay taxes on the gains. So, if you buy Shmosco for $200 and sell it a year later for $220, you only owe taxes on the $20 ($220-$200). The amount that you paid for it is called your “cost basis.”
When you first bought Schmapple, your “cost basis” was $200/share. When you tax-loss harvested and re-bought it for $150/share, that became your new cost basis.
Since $150 is less than $200, you’ll owe more tax in the future if you sell Schmapple at a gain than if you kept your original $200/share shares.
If the Schmapples shares go up to $250 and you sell one share, you’ll owe taxes on $250-$150=$100 rather than $250-$200=$50. But since you already created a $50 loss before, it works out to be roughly (or exactly) the same.
If nothing changes about your tax situation, the benefit of the tax-loss harvest will be the same as the liability.
But, wait, what if your tax situation is different in the future!
Let me borrow an analogy from baseball to examine some changes and how they’d impact you.
Hitting a Single
Imagine that you harvest a tax loss, and several years go by. You eventually sell the position at a gain, and you are still in the same tax bracket.
This is a modestly good outcome (like hitting a “single” in baseball). It’s helpful because, economically-speaking, you received an interest-free loan from the government from the period when you received the tax benefit until you eventually paid the taxes back. Getting a no-interest loan is a good outcome, yes?
Hitting a Double
Now imagine that the situation is similar to the prior example: you tax-loss harvest, several years go by, and eventually sell the position at a gain. But there is a difference. In this example, you are in a lower tax bracket. You were in the Federal 35% bracket, but now you are in the 24% bracket.
This is even better. For example, let’s say you tax-loss harvested $5,714, which resulted in a $2,000 tax benefit 10 years earlier, but when it comes time to settle up with the government, you only owe $1,371 to the IRS ($5714 x 24%)!
In this scenario, you get an interest-free loan from the government, and you also get to pay less taxes overall, which is doubly good.
Hitting a Home Run
Imagine a situation similar to the above, but you never sell the investment, so you never owe taxes. In this situation, you still get a $2,000 tax benefit, but you never have to pay any of it back!
That’s a terrific deal; a home run!
There are two common ways to achieve this outcome:
- If you make a charitable contribution with these appreciated shares instead of cash, the charity gets as much value as you get the same tax deduction. But what about the tax liability? You or the charity doesn’t owe the capital gains liability lurking within those appreciated shares; it effectively just *poof* disappears.
- Under many circumstances, when a person dies, the step-up in basis rule removes any tax liability in many kinds of investment accounts. You don’t pay capital gains tax during your lifetime since you didn’t sell the shares, and your heirs don’t usually pay any capital gains on the amount the shares went up in your lifetime.
But wait, what if my tax bracket goes up?
This can happen, though we rarely see it. If this happens, then you get the benefit of the interest-free loan but you have the cost of however much higher your tax bracket is. These may cancel out, or one could be bigger depending on the precise situation. So, even the bad outcome isn’t all that bad. We’ve never seen a client experience where there was a meaningfully bad outcome but we can imagine ways it would be possible.
Who does tax-loss harvesting tend to help the most?
Tax-loss harvesting tends to work best for people who have one or more of the following characteristics:
- Are in a high tax bracket and have investments in a taxable account
- Will eventually donate some appreciated investment shares to a tax-deductible charity (such as a donor-advised fund)
- Will be able to hold some taxable appreciated securities until their (and any spouse’s) death
Tax-loss harvesting is a powerful tool but can be tricky to understand and implement. If you are in a high tax bracket, are charitable, or are likely to leave appreciated, taxable shares to your heirs, this could be something to learn more about.
*In this example, the taxpayer applied the deduction against ordinary income, and their marginal tax bracket is 24% for federal taxes and 16% for State, county, and municipal income taxes.
Always consult a financial, tax, or legal professional familiar with your unique circumstances before making any financial decisions. This material is intended for educational purposes only. Nothing in this material constitutes a solicitation for the sale or purchase of any securities. Any rates of return are historical or hypothetical in nature and are not a guarantee of future returns, which may be lower or higher. Investments involve risk. Investment values will fluctuate with market conditions and security positions, when sold, may be worth less or more than their original cost.