Investing is all about uncertainty. There is a lot that we just don’t have any control over (though that’s also why investing can be attractive).
Which is why it’s so important to be aware of the areas you can control that can potentially put more money in your pocket.
This includes things like using index funds to minimize expense and eliminate risks that you don’t get paid for, and generally making sure that your investment portfolio is taking an appropriate level of risk so that it fits in with your overall retirement income plan.
But it also includes making sure that you are investing in as tax efficient manner as possible. A big part of this comes down to fund selection and asset location. But you can also use a technique called Tax Loss Harvesting to further reduce your tax hit.
What is Tax Loss Harvesting?
A good place to start is by looking at what tax loss harvesting actually is.
Tax-loss harvesting, when done right, is the equivalent of turning your financial lemons into lemonade, by converting your market losses into tax savings. Successful tax-loss harvesting lowers your taxes without substantially impacting your long-term investment outcomes.
A capital loss occurs when you sell all or part of a position in your taxable account when it is worth less than you paid for it. That loss can then be carried into future years to offset capital gains and other income. You can use losses on a holding’s original shares, its reinvested dividends, or both.
Basically, what you’ve done is generated a substantive capital loss to report on your tax returns without dramatically altering your market positions. We think of it as a kind of “round trip,” that is summarized in these three steps:
- Sell all or part of a position in your portfolio when it is worth less than you paid for it.
- Reinvest the proceeds in a similar (not “substantially identical”) position.
- Return the proceeds to the original position no sooner than 31 days later.
When done correctly, an effective tax-loss harvesting strategy can boost your bottom line by lowering your tax bills. But – like most tax strategies – there are a lot of things that you need to be paying attention to.
But not every loss can or should be harvested. Here are a few common caveats to keep in mind:
What does Substantially Identical mean?
In step 2 above, I mentioned that when you reinvest the proceeds to wait out the 31 day period (more on that in a minute), you can’t use an investment that is “substantially identical.” So, what does that mean?
Well, the IRS wants to make sure that you are actually taking a loss – and not just moving the money from one pocket to another – so they don’t want you to immediately move the money into something that has the exact same risk characteristics of what you are taking the loss on.
But substantially really does mean pretty much identical. So long as you change up the risk characteristics slightly, you are ok. So for instance, if you take a loss on an index fund tracking the S&P 500 Index, you can’t go out and buy another index fund tracking the S&P 500 Index. However, you could go out and buy an index fund that tracks the Russell 1000 Index, which is another large cap stock index. They are very similar, but they are not the same, so the IRS stays happy.
Avoiding the Wash Sale Rule
So let’s talk about that 31 day waiting period. Going along with the IRS wanting to make sure that you are actually taking a loss, you can’t reinvest in a substantially identical investment for 30 days after the sale of the investment you are taking a loss on. This is called the “Wash Sale Rule.”
If you do violate the wash sale rule by buying the same investment (or another one that is substantially identical), the loss is disallowed. But it’s important to note that they consider all of your investments, including ones that you are deemed to have some level of control over – including your spouse’s investment accounts. You’ll also want to keep an eye out for automatic investments, like your 401(k). If you sell that index fund tracking the S&P 500 Index in your brokerage account, but you (or your spouse) automatically buy another S&P 500 index fund in your 401(k), that is a wash sale rule violation and your loss will be disallowed.
It’s pretty easy to violate the wash sale rule, so if you are going to use tax loss harvesting in your retirement plan, you need to make sure that you keep things pretty organized.
Tax Loss Harvesting Pitfalls
While the wash sale rule is the biggest issue to be thinking about when you are using tax loss harvesting, there are still other things that you should be keeping in mind.
Trading Costs
Tax-loss harvesting isn’t always the right answer. If it won’t generate more than enough tax savings to offset the trading costs involved, then it’s not worth it.
I explained it as a three-step process above, but there are really four trades involved:
- Sell the holding
- Buy an interim holding to stay invested during the waiting period
- Sell the interim holding
- Buy back the original position
Each of those trades involves costs, and they could add up to more than you’d save through the harvest.
Getting “Trapped”
We all want our investments to go up. That’s the whole point of investing. And that still is true for our interim holding, but there is a caveat here.
Since we’re not planning on keeping that interim holding for very long, any gains that we have while we are waiting out the wash sale period will be taxed as short term capital gains – and the higher tax rate on these gains can cancel out the benefits of the tax loss harvesting.
If the market goes up while you are in your interim investment, you need to make a choice: do you want to pay the short term capital gains taxes, or stick with the interim investment?
This will really come down to two how much of a gain we are talking about, and how much better your original investment is than your interim investment.
If the gain you have on your interim investment is small, and it doesn’t really have a big impact on the tax loss harvesting benefit, you likely want to get back into the original fund. However, if we’re dealing with a big gain (which is a great problem to have – but it’s still a problem), then we need to think about the difference between our original and interim investments.
Presumably, you think your original investment is a better fit for your portfolio than your interim investment. If it’s not, then this is pretty easy – you just keep your interim investment, and it loses it’s interim label. But if you want to get back to the original investment, you need to consider how much better it is than the interim investment. How much are you giving up by being in the interim investment?
This is important because you need to decide how much you are willing to pay in taxes to get back to the original fund. This might involve waiting until the market pulls back, and the gains in the interim fund go away, or it might involve waiting the full year until those short term gains turn into long term capital gains (with their lower tax rates).
These Taxes Don’t Go Away
One of the biggest misconceptions about tax loss harvesting is that the taxes go away. They do in the immediate sense – your tax bill will be lower in years where you do tax loss harvesting (if you do it right), than if you didn’t do it – but you’re really shifting those taxes out into the future.
This is really valuable – all else equal, I would rather pay my taxes in the future than today. But those taxes (usuall) still need to be paid. Think about what tax loss harvesting is really doing. We are lowering the cost basis on your investment. And when we go to sell that investment in the future to generate income in retirement the taxes will be that much higher.
One of the few exceptions to this is if you don’t sell these positions during your lifetime, and your heirs get the step up in cost basis when they inherit your portfolio. However, since the taxable portfolio is usually the first one that we spend in retirement, this isn’t super common.
Stick to the Plan
Tax loss harvesting can be a really powerful tool to manage your taxes on a year to year basis. But your overall retirement plan is much more important.
Nothing that you do to harvest losses should substantially impact the amount or type of risk that you are taking in your investment portfolio. It’s easy to get excited about tax loss harvesting and push it as far as you can, and harvest all of your losses. But you should only do that if you are comfortable with what your portfolio will look like while you’re waiting out the wash sale period. Thirty-one days may not sound all that long, but the market can move fast, and if the market decides to make a big move – up or down – while you are not in the portfolio you designed, that can have devastating impacts.
Nobody likes market downturns, but they’re an unavoidable part of investing. Losses can often be softened through tax-loss harvesting, but that’s not always the case. Figuring out if, when, and how to take advantage of a tax-loss harvesting opportunity while skirting obstacles is one way we add value for our clients.
To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.
