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It’s that time of year again. December is the final call for (most) annual tax issues, and the topic of tax-loss harvesting rears its head. Let’s break down the basics and ask an important question: is tax-loss harvesting more than a simple fad?
Before answering the critical question (“Is tax-loss harvesting worth it?“), let’s baseline ourselves with some basics.
What is Tax-Loss Harvesting, and Why Bother?
Tax-loss harvesting is a strategic investment practice where investors sell assets at a capital loss to offset other capital gains. This minimizes taxable income. This technique is commonly employed to optimize investment portfolios and enhance after-tax returns.
Here’s a primer on capital losses, capital gains, and the entire capital gains tax structure.
Why bother tax-loss harvesting in the first place?
You might have assets in your portfolio with unrealized losses. Selling those assets turns that lame asset into a “tool” in your toolbox. That tool can neutralize taxes, lowering this year’s tax bill. Not bad, right?!
Losses can even neaturalize future year tax bills! Any unused losses this year are tracked on your tax returns and, eventually, can be used to cancel a future year’s capital gain.
But there’s more to the story. We’ll get into those details later.
The Wash Sale Rule
Tax-loss harvesting has a limitation. When you sell an asset at a loss, a 30-day look back and a 30-day look forward period bookend that sale. If, during those 61 days (30+1+30), you bought a “substantially identical” asset in any account**, then your capital loss doesn’t count.
The wash sale rule prevents manipulating a stock portfolio to accelerate the recognition of tax losses or defer the recognition of tax gains.
**This is a huge detail many people miss. The Wash Sale Rule looks at all investing accounts from which an owner controls or benefits.
If you execute tax-loss harvesting in your taxable account by selling an S&P 500 index fund at loss, then you cannot trade materially similar S&P 500 index funds in any accounts (IRA, 401(k), HSA, 529, etc) during the 61-day wash sale window. This even includes innocuous occurences, like a previously held S&P 500 fund paying out a dividend which is automatically reinvested.
If you’re going to tax-loss harvest, you need awareness of all your investing accounts.
If you plan on tax-loss harvesting, you must know the wash sale rule.
When is Tax-Loss Harvesting Worth It?
When misused, tax-loss harvesting can be a net-zero or even harmful activity. Let’s talk through some good and bad examples.
Good: Tax-Loss Harvesting to Offset a Liquidation Event
Perhaps you’re selling a business or a second home (primary homes typically don’t suffer capital gains taxes) and facing a significant capital gain from that sale. Tax-loss harvesting makes sense here.
Why?
In this scenario, you’re making the sale anyway. You might as well seek out ways of saving money. You’re fundamentally reallocating your net worth away from the real estate or business to something new (perhaps a stock/bond investment portfolio).
The gains and losses are from different pools of money, which permanently offset one another. This is good. But as we’ll see later, this isn’t always the case.
Example:
- You sell a business for a $500,000 (long-term) capital gain.
- As it happens, the S&P 500 index fund holdings in your taxable account are down $100,000 from where you bought them (also long-term).
- You sell all of the S&P position, realizing a $100,000 loss.
- That loss offsets $100,000 of the business gains.
- Now you only have to pay taxes against $400,000 of gains (likely saving at a 23.8% Federal rate, or saving ~$23,800)
- You re-invest the $100,000 proceeds of the S&P 500 fund in a similar but not materially identical manner. “Similar” because we want to maintain our overall portfolio allocation. But “not materially identical” because we don’t want to violate the wash sale rule. A good candidate here would be an “Total US Stock Market Index Fund” to replace our S&P fund.
- You invest the business proceeds (less remaining capital gains taxes) according to your financial plan.
Good: Offsetting Income (Usually)
You can use tax losses to offset up to $3000 in annual earned income. This is an excellent use of tax-loss harvesting (usually).
The reason is tax-rate arbitrage.
Many taxpayers have a Federal tax rate of 22% or higher. Every dollar of income they can offset results in a 22% (or greater) savings. Meanwhile, harvesting tax losses usually creates a 15% capital gain in the future (we’ll discuss how and why this is below).
By saving 22 cents today and spending 15 cents in the future, taxpayers can arbitrage a net 7% on their $3000 for free. The benefit is even more stark in higher brackets (24%, 32%, 35%). Not bad!
Another common tax arbitrage occurs when an investor might owe capital gains at the 23.8% bracket. Losses can offset those gains (saving 23.8%), likely resulting in a 15% capital gains tax later on. That’s a deal we’d take every time.
Good: Diversifying from Over-Concentration
Uncle Ed bequested 10,000 shares of the ACME Corporation to you in 1990 at $1 each. Now they’re worth $20 each. You own $200,000 of ACME, representing a considerable over-concentration in your portfolio (and a huge capital gain if you try to diversify away from it).
Similar to the business example from above, diversifying away from ACME is something you should be doing anyway. You might as well reduce your capital gains tax while doing so.
Bad/Neutral: Zero’ing Out Gains in Your Portfolio
Perhaps the most common reason I see people tax-loss harvest is to zero out gains inside their portfolio. They have (unrealized) losses on their books and feel the need to use them. So, they think they might as well realize gains in the portfolio, use their losses to negate the gains (and negate this year’s taxes), and then reinvest the proceeds.
I think this is, at best, a neutral use of tax-loss harvesting, not to mention a waste of time. The math explains why.
First, by reinvesting all the proceeds of the transactions, the overall portfolio construction doesn’t change. There’s no fundamental investing benefit (unlike the earlier example of diversifying a concentrated position). And there’s no factor of “I’d be doing this anyway,” like the earlier example of selling a business.
But is there a tax benefit?
No, there’s no net tax benefit. The assets with gains get an increase in cost basis, while the assets with losses get a decrease in cost basis in equal magnitude, leading to zero change in the overall cost basis of the portfolio.
This means that any capital gains you “saved” this year will simply be paid in a future year.
Now, if you think you’ll pay at a lower tax rate in that future year, that’s worthwhile; it’s the tax arbitrage benefit we discussed before. But in most real-life examples I’ve encountered, there’s no arbitrage. It’s just a postponing of the inevitable for no net benefit.
What About the Time Value of Money?
“Postponing the inevitable” might be a good thing in some cases.
Would you rather pay $1000 in taxes today, or $1000 in 10 years? The answer is easy: in 10 years.
The benefit of tax-loss harvesting – simple tax deferral – is technically good. But, in my opinion, only becomes worthwhile at large dollar amounts for long periods of time.
If you’re able to defer $100,000 for 10 years, then go ahead and use tax-loss harvesting. But if you’re deferring $500 for a year, the juice isn’t worth the squeeze.
Other Bad Scenarios
Tax-loss harvesting has other downsides. Some scenarios include:
Losses Must Negate Gains First
When you realize a capital loss, it must be first-and-foremost used to offset capital gains – even if you don’t want it to.
- You want to use losses to offset regular taxable income? Only if you’ve already offset all your capital gains.
- You happen to be in the 0% capital gains bracket this year, and so you want to “pay” that 0% tax? Too bad. Your losses negate those gains – a.k.a. your losses were used for zero real benefits.
Without careful tax planning, your tax losses might be wasted.
Death Ends the Conversation
If a taxpayer dies with unused tax losses, the opportunity disappears forever.
Questions of mortality should be thoughtfully considered as part of a long-term tax plan.
Tax-loss harvesting, like all tax planning tactics, should never be considered in a vacuum. There are simply too many complicating factors involved. Instead, tax-loss harvesting is a tool to be used as part of a long-term tax plan.
Thank you for reading! If you enjoyed this article, join 7000+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week.
-Jesse
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Source: bestinterest.blog
