No one ever sets out to lose money. Yet, no matter how good of an investor you may be, there will be times where you have to move on from a troubled investment and accept a loss. Sometimes the business itself has changed and the reason you initial invested in the company no longer exists. Once in while you will simply be wrong, and find it is time to move on from a bad investment. Regardless of the reason, tax-loss harvesting can help you turn realized loss into tax savings, strengthening the foundation of your future success.
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What is Tax-loss Harvesting:
Tax-loss harvesting is a process where an individual investor sells particular investment holdings at a loss to lower their tax bill. Tax-loss harvesting can reduce your tax bill in three ways:
- If you have any taxable capital gains in the year, you can first subtract any recognized taxable losses from that amount.
- Short term losses are first deducted from short term gains and vice versa for long term losses. Net losses can then be subtracted against the other period.
- If your realized losses exceed your taxable gain in the year, you can subtract up to three thousand dollars from your earned income.
- You can carry forward any amount of left over losses to subsequent tax years until the entirety of your losses has been accounted for.
An all too common fear around investing is a fear of losing everything. The risk of loss is real. You should never invest beyond what you can afford to lose. However, systems such as tax-loss harvesting exist to reduce this risk. Tax-loss harvesting can effectively cap your loss at 100% – your effective tax rate at the federal level. The majority of states treat tax-loss harvesting in a similar manner though some states have additional restrictions such as disallowing the writing down of income in future years.
What Accounts are Eligible for Tax-loss Harvesting
Tax-loss harvesting merits consideration within any account where a sale of equities constitutes a taxable event. In the case of tax-deferred accounts, including most retirement accounts, the benefits of tax-loss harvesting would not apply.
Is Tax-loss Harvesting Worth the Effort:
Recent events in the investing world, including the widespread availability of transaction fee-free trades, and the requirement for brokerages to keep track of investors’ cost basis, have removed significant barriers once inherent in Tax-loss Harvesting. With Tax-Loss Harvesting becoming a viable option for more and more investors, the pertinent questions become:
- Is Tax-loss Harvesting worth the effort?
- Does it Significantly increase an investors returns?
Multiple studies from accredited institutions including MIT, Chapman University, and a study by Shomesh E Chaudhuri, Terence C. Burnham, & Andrew W. Lo titled “An Empirical Evaluation of Tax-Loss-Harvesting Alpha” consistently show that the application of tax-loss harvesting has the potential to increase the performance of the underlying portfolio by .5% to ~2% annually.
With an average return of roughly 10% a year for the overall market, an additional 1% from tax-loss harvesting could substantially impact your life in retirement. Let’s pretend that you:
- are forty-five years old
- have a modest $10,000 currently invested
- will invest an additional $10,000 annually until your retirement in 25 years
A ten percent average return will allow your investments to grow to just over one million dollars over twenty-five years. If you managed to up this average return to eleven percent annually, that same investment portfolio would be worth 1.28 million dollars or roughly 17% more.
Note that waiting 30 days to reinvest your money into the same company may lower you return on average:
When the strategy was constrained by the “wash sale rule,” the tax alpha decreased from 1.08% per year to 0.82% per year.
From <https://doi.org/10.1080/0015198X.2020.1760064>
If you instead elected to immediately invest your money in a sufficiently different company you returns become more difficult to predict and outside of the scope of most published studies.
Tax Loss Harvesting Timing
Each April, you are settling taxes from the prior calendar year. To qualify for a deduction, investors must realize the loss by Dec 31st. While you can have a qualified loss at any point during the tax year, related activity tends to spike throughout the fourth quarter.
Individual investors are encouraged not to wait until the last moment to preserve the flexibility needed to execute a sale at their price. Those waiting until the deadline may find themselves forced to rely on market orders to see them filled.
Tax Loss Harvesting Rules: Wash Sale Rule
The strategy of tax-loss harvesting is limited by a regulation called The Wash Sale Rule. To realize a tax benefit on any loss, an investor may not repurchase the same (or a substantially similar) investment within thirty days of the sale. This rule, implemented in the 1920’s as a disincentive for investors to blindly sell off investments every time they drop in value, has come to the forefront in recent years. In 2008 Congress passed legislation to require brokers to track the cost basis of individual holdings. The new reporting requirements resulted in brokers reporting wash sales to the IRS. The thirty day lockout includes contracts or options to buy such a security in the future, and holds across all accounts in the investor’s name.
If you sold Apple at a loss you would have to wait thirty days to purchase new shares. You could immediately sell Apple and fill the void with Microsoft. If you owned a fund that tracked the S&P500, you could replace it with a fund tracking the NASDAQ or a total market fund. Under the current implementation, you may even be able to buy a different fund that tracks the same index.
If a company were to sell two classes of stock, both with the same voting rights, or which could directly be converted from one class to the other, you could not sell shares of one and replace them with another. The IRS would consider them substantially similar investments and your actions would trigger a wash sale.
Wash Sale Rule on Cryptocurrency Holdings:
While the IRS taxes cryptocurrency gains equivalent to capital gains on stocks, the wash sale rule does not [currently] apply to these investments. Let’s pretend for a moment that you purchased a single Bitcoin in October when it hit $65,000. Fast forward to next December and imagine that coin’s value is now just under $50,000. Not only can you sell your position and use the $15,000 loss against any capital gains you might have (or ordinary income if you don’t), you can also repurchase Bitcoin immediately.
This exception is under fairly heavy scrutiny and may change in future tax years.
When Tax-loss Harvesting May Not Make Sense
Single filers who earn less than $40,400 annually, or joint filers earning less than $80,800, pay nothing on capital gains. These threholds are adjusted over time, see the current rates here. If you find yourself in this situation, you might take advantage of the inverse process of gain harvesting, selling your winning stocks, and immediately repurchasing them (the wash sale rule only applies to losses). This process will allow you to reset your cost basis now when you are subject to no tax on your capital gains.
Note that if the realized gain would push your income above the minimum threshold then only the gains above that threshold will result in capital gains tax.
Tax-loss Harvesting Can Help You Move On
Investing is a difficult and often irrational game. You will have losses. Some of those losses will come from companies you still believe in, losses you may not be able to easily explain. Some will come about because the underlying story has changed. The latter presents you an opportunity to leverage tax-loss harvesting to move on, using those losses to lower your tax bill and reinvest in a company that will move your journey forward.