Nobody likes to own a losing investment. It can be difficult to convince yourself to sell it because of the sunk cost fallacy. You have to admit that you’ve made a mistake and didn’t have the ability to predict the future. Who likes being wrong? But once you get over yourself, there is a silver lining in that Uncle Sam will share in your losses. Up to $3,000 per year in net investment losses can be deducted form your ordinary income. For a typical lawyer, that’s worth $1,000 to you. If the losses exceed $3,000, you can carry over the deduction and apply it to your future tax returns.
But an intelligent investor can take advantage of market downturns to generate losses on long-term assets without losing a dime. Here’s how you do it.
TAX LOSS HARVESTING – HOW TO DO IT
Step 1) Purchase investments in a taxable account that you intend to hold for a long time. This is not about market-timing, speculating, or purchasing specific types of investments just for the sake of implementing tax loss harvesting. Buy the things you would have bought anyway.
Step 2) When the assets decline in value, instead of freaking out and selling the investment for a loss, you simply “harvest the loss”. This generates a paper loss for you which allows you to take the tax benefits for selling the “losing” investment but does not impact your long-term investment results. How do you do that? By swapping the current investment with one that is highly correlated but not identical. The result is that your portfolio hasn’t changed (you swapped one highly correlated asset for another) yet you still have generated a tax loss which you can claim on your taxes.
EXAMPLE OF TAX LOSS HARVESTING
Let me give you an example.
On March 1st you purchased $10,000 of Vanguard Total Stock Market Index Fund (VTSAX). On July 1st you’ve noticed that the market is currently down 10% since you made your investment on March 1st. So on July 1st you exchange your shares in VTSAX for the Vanguard Large Cap Index Fund (VLCAX). The new fund has a correlation of close to 99% to the old fund, so you have essentially traded one investment for another. However, this exchange is not considered “substantially identical” by the IRS. You’ve now booked a loss of $1,000. Given a 33% federal tax bracket, you will save $333 on your federal taxes. If the market continues to trend down, you can do it again. The only caveat is that you’ll have to remember that you cannot make an investment in VTSAX for at least one month or the “wash sale” rule will eliminate the tax break.
What’s the Wash Sale Rule?
From IRS Publication 550:
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.
CRITICS OF TAX LOSS HARVESTING
Some investors are quick to point out that you’ll end up paying more taxes later because you’ve lowered your basis in the investment. That is absolutely correct. In the example above, you’ve lowered your basis in the investment from $10,000 to $9,000, so when you ultimately sell the investment you will be required to pay taxes on any gains above $9,000 (rather than $10,000).
There’s still some reasons why this is a good idea.
First, you’re deferring taxes and there’s inherent value in tax deferral strategies (some even say that a tax deferred is a tax avoided). By taking the tax break today, but paying taxes in the future, you’re taking advantage of the time value of money by having access to the extra funds today which could be invested themselves and earn compound returns. Also, don’t forget that there are strategies to flush out capital gains from your portfolio, such as donating appreciated stock to charity rather than giving cash directly.
Second, there’s tax arbitrage in deducting at your regular federal tax income rate (33% in the example) and paying future capital gains at a 15% rate. That’s an 18% savings right there that should be encouraging for anyone looking to minimize taxes.
While many young lawyers may have no need for a taxable account, since they should be focused on maximizing retirement accounts, there may not be much reason to take advantage of this strategy. For me, I’m focused on maximizing retirement accounts and saving for a down payment, so there’s not much point for a taxable account for me. However, if you have a taxable account, dips in the markets are a great time to take advantage of tax loss harvesting.
Now you also understand what the roboadvisors (Betterment, Wealthfront, etc.) are doing through their algorithms to generate the extra portfolio returns by tax loss harvesting automatically for you.