"What is tax-loss harvesting, and how can I take advantage of it?"

Important takeaways

• Investment losses are painful, but they could help your tax bill
• If you “recognize” a tax loss, you can offset current or future taxable gains
• If there are no capital gains to offset, you can use up to $3,000/year in losses to reduce your ordinary income
• You can carry forward those losses for an unlimited number of years until the losses are exhausted
• Be careful of the “wash-sale rule.”

Stock market losses create opportunity

Let’s be transparent, market losses are painful for everyone.  Typically a steep selloff comes after a period of significant gains, and you probably got used to seeing positive returns quarter after quarter, until the selloff begins.  Whether it’s the recent mix of inflation + interest rate hikes + global conflict + supply chain issues, or perhaps the onset of the global pandemic in 2020, the oil crash of 2018, China devaluing it’s currency in 2015, or the Great Recession of 2008 (on and on).  There is typically a feeling of capitulation at the bottom of the market after a prolonged selloff until prices begin to recover.  And oftentimes, the recovery is a bumpy road of ups and downs. During these volatile times, I’ve talked about the idea of re-balancing to ensure your investment strategy is aligned with your goals for retirement, or saving for college, or saving for that dream vacation home.  These dips in the market have generally proven to be great buying opportunities for long term investors. In this article, however, I want to talk about a tax strategy known as “Tax-Loss Harvesting” that you might want to consider while the market is down from it’s previous highs.

What is Tax-Loss Harvesting?

First and foremost, I want to clarify that taking a loss on a stock, bond, mutual fund or ETF can only be done outside of a qualified plan for tax purposes.  This would exclude accounts like 401ks, IRAs, Roth IRAs, 403bs, Annuities, Life Insurance, 457b plans etc.  In short, the account must be a taxable account.  With taxable accounts, you receive a 1099 each year for interest earned, capital gains realized/distributed, dividend income etc.  Many people have the mindset to try to ride out the storm during volatility, which is not a bad move.  However, you can ride out the storm and realize some significant tax benefits along the way by using the tax loss harvesting strategy. 

In order to realize the loss, you must sell the asset.  Whether it be a stock, bond, mutual fund, ETF or even a digital asset like bitcoin, you have to hit the sell button and turn it into a realized loss from a paper loss.  Once you have realized the loss, you can use this loss as an offset to current or future capital gains.  If you don’t have any capital gains to offset, you can use the loss as a tax deduction against your regular income (up to $3,000/year).  If you have more than $3,000 of losses, you can carry forward those losses to future tax years, until the loss is fully exhausted.

Let’s use an example.  You bought Apple for $20k at the start of the year, and now it’s down to $14k.  You like Apple, but you also like the idea of realizing the loss for tax purposes, and you might consider buying back into the stock (or another stock) later on.  You decide to sell all of your shares, and you now have $14k in cash and a $6k short term loss.  Let’s assume you did not have any gains for the year to offset against.  When you are filing taxes for that calendar year, you can use $3k of your loss as a tax deduction, regardless of whether or not you itemize or take the standard deduction.  The final $3k of losses can then be carried forward to the next tax year to either offset future gains or deduct against income.

Let’s use that same scenario of buying Apple for $20k and selling it for $14k.  However, let’s also assume you bought Tesla at the beginning of the year for $20k and it shot up to $30k, and you sold out of that position as well.  Normally, you would have to pay taxes on the full gain of $10k from selling TSLA, but because you had the realized loss of $6k from selling Apple, you will only have taxable income in the amount of $4k ($10k-$6k).

Short term vs Long term losses

When you sell an asset you’ve owned for one year or less, it is known as a short term gain (or loss).  When you sell an asset you’ve owned longer than one year, you would have a long term gain (or loss).  The important difference is the taxation of short term vs. long term gains. Short term capital gains are treated as ordinary income, and the normal tax brackets apply (see graphic below for 2022 brackets).

Long term capital gains have more favorable tax treatment, and follow the tax schedule shown below.

Let’s say your combined income (married filing jointly) is $200,000/year. The top marginal rate you will pay for ordinary income (which includes short term capital gains), would be 24%. However, if you held the asset longer than one year, the 15% rate would apply.

The IRS guideline is to offset gains of the same type first, and then use excess to offset other gains, or of course deduct against your income (up to $3,000/year).   In our earlier example of Apple and Tesla, we had a net short term gain of $4k.  However, let’s say we instead had purchased Tesla a decade ago resulting in a long term capital gain.  If we had NO other short term gains to offset, we could either deduct the $6k loss from Apple against the long term capital gain of Tesla (less advantageous), or carry that forward and use as an income tax deduction (potentially more favorable). 

When planning for retirement income, a large portion of the withdrawals, especially early on, will come from these taxable accounts.  401ks and other qualified plans have limitations on withdrawals before 59 1/2, so for those of you looking to retire early, these non qualified accounts are critical.  If we have a large batch of losses that we’ve carried forward for years, or even decades, this can substantially lessen the tax impact of withdrawals from these taxable accounts. 

You may also be wondering, what if I want to keep that position for the long term? 

There is a rule within the IRS code called the wash-sale rule.  This means, in order to write off the investment loss, you must not purchase the same or “substantially identical” investment 30 days before or after the sale.  Therefore, if you sell Apple and realize a $10k loss, you have to wait 31 days before you buy back into Apple.  For individual stocks, this makes this strategy a bit complicated.  There is no company you could replace Apple with and call it a fair trade.  However, you might be okay with waiting 31 days before buying back in, or replacing that stock with another that might have similar characteristics.  With a mutual fund or ETF you have to understand what “substantially identical” means.  The IRS is somewhat vague in this regard, but this Publication 564 stated: 

“In determining whether the shares are substantially identical, you must consider all the facts and circumstances. Ordinarily, shares issued by one mutual fund are not considered to be substantially identical to shares issued by another mutual fund.”

Given the S&P 500 currently has 505 stocks, and there are hundreds of mutual funds and ETFs that track this particular index, are all of these “substantially identical?”  It seems the answer is “no,” as having a different fund manager, a different style of management, or even a different expense ratio are enough to mitigate the risk of triggering a wash-sale.  However, use caution, consult your financial advisor and/or tax advisor before you pull the trigger to avoid this wash-sale rule. If you get it wrong, you could owe some serious back taxes without even realizing it.  

With this assumption, I like to take the approach of using an active vs. passive fund style when harvesting losses in ETFs or mutual funds.  For example, you may own Schwab S&P 500 Index (SWPPX), which is a passively managed ETF that tracks the S&P 500 index.  You want to take advantage of tax loss harvesting, but you want to keep your exposure to the S&P 500, just in case the market goes on a run in the near term.  Instead of replacing it with a fund like Fidelity S&P 500 Index Fund, which is also a passively managed S&P 500 index fund, you may want to buy an actively managed large cap US mutual fund, like JPMorgan US Equity Fund (JUEAX), as an example.  That actively managed fund will still give you the large cap US exposure, but would not be characterized as “substantially identical.”  Furthermore, if you were really in love with that passively managed ETF (SWPPX), you can wait 31 days to buy back in by replacing the actively managed fund you initially swapped it with.

Currently, cryptocurrencies do not follow the wash-sale rule. 
Therefore, you could theoretically sell bitcoin, realize a tax loss, and
buy back in right away to maintain your position.

In Summary

Volatility is painful for everyone!  You are not alone, and the pundits on TV or “social media influencers” that were bragging about their gains are now silent.  In times like this, I like to remind you of one of my favorite quotes from Warren Buffet, “Be fearful when others are greedy, and greedy when others are fearful.”  If you are feeling fearful during a sell off, it’s normal.  Consult your trusted advisors on what the best strategy is for you. 

If you can benefit from recognizing losses in a taxable account, make sure you have an exit and entry strategy so you avoid missing out on a sharp recovery and be careful of the wash-sale rule.  And just because you don’t have any gains to offset in the current year, those carry forward losses could benefit you for years, or even decades in the future. 

Do you have questions or want to schedule a meeting to discuss working with our firm? You can book a 30 minute “Mutual Fit” meeting below to learn more.