By Dr. Jim Dahle, WCI Founder
One benefit of a market trending down is that an investor can get Uncle Sam to share in their losses by tax-loss harvesting. Up to $3,000 a year ($1,500 married filing separately) in net investment losses can be deducted from your regular income. In a typical physician tax bracket, that's worth about $1,000 in cold hard cash. If you have more losses than $3,000, the loss can be carried over and applied to your future tax bills.
For many people, it is hard to sell a losing investment. You have to admit you didn't have the ability to tell the future. Once you admit that your crystal ball is always cloudy, you realize that the intelligent investor can take advantage of the downturn.
What Is Tax-Loss Harvesting?
You are allowed to deduct up to $3,000 per year of a short- or long-term capital loss from your ordinary income on your taxes. Losses also offset gains. This all takes place on Schedule D of IRS Form 1040. These losses are so useful that investment advisors, tax preparers, and financial gurus the world over recommend you book them any time you can. However, taxable losses generally show up after an investment goes down in value, not exactly the time you would normally sell an investment. Buying high and selling low is a losing proposition most of the time.
Thus, the birth of tax-loss harvesting.
When tax-loss harvesting, you get to claim the loss without ever selling low. You do so by simply exchanging one investment for a very similar (but, in the words of the IRS, “not substantially identical”) investment. You're still fully invested (and so haven't “sold low”) but still get to use the loss on your taxes.
How to Tax-Loss Harvest
I wrote about this in 2018 when describing how to tax-loss harvest through my Vanguard account. But here's a good rundown of how to think about it.
#1 Buy and Hold Investments You Want to Hold for a Long Time
If you're not jumping around in the market, market-timing, and speculating, then you've bought investments that you want to hold even if they go down temporarily.
#2 Harvest Losses in a Decline
When they decline in value, instead of panicking and just selling them completely, you “harvest the losses.”
#3 Trade for Something Similar
You get the tax benefits just for selling the losing investment. But if you don't trade it for something similar, you commit the cardinal investment sin of buying high and selling low. The wise investor SWAPS the losing investment for one that is highly correlated with it. The net effect is that your portfolio doesn't change substantially, yet you still get to claim the losses on your taxes. As an example: A typical exchange might be to swap the Vanguard Total Stock Market Fund for the Vanguard 500 Index Fund. These two funds have a correlation of 0.99, but nobody in their right mind could argue they are substantially identical. The first holds thousands of more stocks than the second, they have different CUSIP numbers, and they follow different indices.
Need some help in figuring out which pairs you can swap? Here's an extensive guide on tax-loss harvesting pairs and partners.
Tax-Loss Harvesting Rules
There are a few important tax-loss harvesting rules.
Substantially Identical Rule
This means you could swap a Vanguard Total Stock Market Fund for a Vanguard 500 Index Fund, but you couldn't swap a Vanguard Total Stock Market Fund for a Vanguard Total Stock Market ETF. Those are substantially identical. Now, some people think the IRS really dives into the details of these transactions, but I don't know anybody who knows anybody who has ever been audited on this point. The IRS has bigger fish to fry. So, I really wouldn't spend any time worrying about it. Certainly, in this case, one fund holds thousands more stocks than the other, so it is an easy argument to make that they are not identical. You can also argue that two indices and the holdings themselves are different even if you're using a Total Stock Market fund from two different companies.
Wash Sale Rule
The easiest rule to screw up tax-loss harvesting is the wash sale rule. That means you can't turn around and buy the same security in the 30 days after you sell it—if you do, the basis is reset and that loss you were trying to get is washed away. You also can't buy it in the 30 days BEFORE you sell, UNLESS you also sell the shares you just bought.You also can't buy the same security in an IRA that you just sold in taxable. The tax code doesn't say you can't buy it in a 401(k), but I think that is at least against the spirit of the rules.
Be careful buying and selling frequently, of course. If you don't hold a security for at least 60 days around the dividend date, you will turn that dividend from a qualified dividend into a non-qualified dividend, eliminating a lot of the benefit of that tax loss.
60 Day Dividend Rule
Don't forget that owning a security for less than 60 days around (including before or after) a dividend date turns a dividend that would have otherwise been qualified into an unqualified dividend. You pay a much lower tax rate on qualified dividends than non-qualified dividends. So if you start frenetically tax loss harvesting, you could end up paying MORE in taxes. Slow it down, especially around dividend dates.
When to Do Tax-Loss Harvesting
In June 2018, there was a period of time where stocks dropped for about six days straight. There were similar episodes, at least for international stocks, in February, March, and May of that year, as well. If you had purchased an international stock index fund at any point during 2018, chances were very good by June 19 that you had a loss you could tax-loss harvest, especially if you had not already done it for that year. (Obviously the really astute probably already did this in February, March, or May.)
That's one example of when it would have been a good time to tax-loss harvest.
Remember, though, you're likely having to pay administrative costs whenever you're exchanging funds. You need to make sure that your tax gains will be higher than the costs you're having to pay.
An Example of Tax-Loss Harvesting
The Stock Purchase
On March 14, you bought $5,000 worth of Vanguard Total Stock Market Index Fund (TSM) at a price of $32.64 a share and $5,000 worth of Vanguard Total International Stock Market Index Fund at a price of $15.67 a share.
The Exchange
On Friday, August 5, you exchanged the TSM for Vanguard Large Cap Index Fund, selling the shares of TSM at $29.99 a share and exchanged the TISM for Vanguard FTSE Ex-US Index Fund, selling the shares of TISM at $14.66 a share.
The new funds have a correlation with the old funds of something close to 0.99. It's essentially identical for investment purposes. But per the IRS, the investments are not “substantially identical” for tax purposes.
Booked Loss
You have now booked a total loss of $728.22. Given a 32% federal tax bracket and a 5% state tax bracket, you've now saved yourself $728.22 × (0.32+0.05) = $269.44 in taxes. The best part is that if the market trends down, you can do it again tomorrow. You just have to remember not to go back to TSM and TISM for at least a month, or the “wash sale” rule eliminates your tax break.
The Critics
Some critics point out that you'll end up paying later the tax you save now because you've lowered your tax basis on the investment. That is true, but there are several reasons why it is still a good idea.
- First, there's a tax arbitrage here. You get to deduct taxes at your regular income tax rate, 37% in the example, but only have to pay at the capital gains tax rate later, say 15%.
- Next, there is a benefit to deferring the taxes as long as possible. Money now is worth more than money later—due to inflation and also due to the time value of money.
- Last, it's possible you'll NEVER have to pay taxes. If you later use the shares for a charitable donation (in which case neither you nor the charity pays the tax) or if you die and leave them to heirs (in which case there is a step up in basis to the value of the investment on the date of your death), then you'll never have to pay that tax.
Remember that you can only tax-loss harvest in a taxable account.
But if you do have a taxable account, the next time there is a downturn in the market, see if there is some tax-loss harvesting you can do. It won't necessarily allow you to FIRE tomorrow, but it could provide some nice tax savings.
What do you think? Do you tax-loss harvest investment losses? Why or why not? Comment below!
[This updated post was originally published in 2019.]
As an enthusiast with a deep understanding of financial strategies, particularly tax-loss harvesting, I can confidently provide insights into the concepts discussed in the article by Dr. Jim Dahle.
Tax-loss harvesting is a tax-efficient investment strategy that allows investors to offset capital gains by selling investments that have experienced a loss. The key benefit is the ability to deduct up to $3,000 per year (or $1,500 for married filing separately) in net investment losses from ordinary income on taxes. This can result in significant tax savings, especially for individuals in higher tax brackets.
The article emphasizes the advantage of tax-loss harvesting during market downturns, where investors can strategically sell losing investments without completely divesting from the market. The process involves exchanging a losing investment for a similar, yet "not substantially identical" one, allowing the investor to claim the losses on taxes without violating the wash sale rule.
The substantially identical rule is crucial in tax-loss harvesting, as it dictates that the replacement investment must not be substantially identical to the one sold. The example provided involves swapping the Vanguard Total Stock Market Fund for the Vanguard 500 Index Fund, which are highly correlated but not considered substantially identical.
The wash sale rule is another critical aspect to consider. It prevents investors from repurchasing the same security within 30 days after selling it, as doing so would reset the basis and nullify the intended tax benefits.
Additionally, the article highlights the 60-day dividend rule, cautioning investors about the potential impact on dividends if a security is held for less than 60 days around the dividend date. This underscores the importance of careful planning to avoid unintended tax consequences.
Timing is a crucial factor in tax-loss harvesting, as illustrated by the example of a market downturn in June 2018. Investors need to balance the potential tax savings with the administrative costs associated with exchanging funds.
The article concludes with an example of tax-loss harvesting, demonstrating the financial impact and potential tax savings. Critics argue that while tax savings are immediate, the lowered tax basis on the investment may result in higher taxes later. However, the author contends that tax arbitrage, deferring taxes, and potential scenarios where taxes may not be payable make tax-loss harvesting a viable strategy.
In summary, tax-loss harvesting is a sophisticated yet valuable strategy for investors to optimize their tax liabilities during market downturns, providing an opportunity for tax savings without completely abandoning their long-term investment goals.
