[0:00] Tax loss harvesting may sound fancy and complicated,
but I promise it’s super simple, and you’ll
[0:04] have a better understanding of it after watching
this video.
[0:07] Here we’ll explore what tax loss harvesting
is, why and how you’d want to do it, the
[0:12] rules, limits, and deadlines involved, examples,
and how to avoid the infamous “wash sale”
[0:17] in your portfolio.
[0:18] What Is Tax Loss Harvesting?
[0:20] Tax loss harvesting just refers to selling
investments at a loss to lower your tax burden.
[0:25] Simple as that.
[0:26] Specifically, we’re talking about selling
positions that have unrealized capital losses
[0:30] at the time of sale in order to offset realized
capital gains (or taxable income, if you don’t
[0:35] have any realized gains) for that year.
[0:37] If used to offset realized capital gains,
those gains can be short-term or long-term,
[0:41] the former of which are taxed at higher rates.
[0:43] In other words, realized losses can be used
as a credit against any realized gains during
[0:48] the year.
[0:49] We call this sale “harvesting” the loss,
hence the name tax loss harvesting.
[0:53] Tax loss harvesting to offset that year’s
gains or income must be done by the end of
[0:58] the calendar year, so the deadline is December
31.
[1:01] Naturally, this encourages many to employ
a strategy of checking the portfolio at the
[1:05] end of the year to harvest any losses, but
tax loss harvesting can actually be used anytime
[1:10] your position in a security has an unrealized
loss throughout the year.
[1:13] Day traders will use this as a tool to offset
short-term capital gains.
[1:17] If the long term investor is simply holding
and has no realized gains, their harvested
[1:22] losses can reduce their income tax liability.
[1:24] So far tax loss harvesting sounds like a great
way to reduce one’s tax liability.
[1:28] Unfortunately there are some limits and rules
to abide by.
[1:31] First, if the long term investor mentioned
previously who has no realized gains wants
[1:35] to harvest losses to reduce their taxable
income, they can only do so up to a limit
[1:40] of $3,000 per year if single or married filing
jointly.
[1:44] That is, if your realized net loss on your
investments at the end of the year is $5,000,
[1:48] you can only deduct up to $3,000 from your
taxable income for that year, but you can
[1:53] also carry forward the unused loss of $2,000
to harvest in the future.
[1:58] Secondly, there’s an important tax loss
harvesting rule from the IRS known as the
[2:02] wash sale rule that prohibits investors from
using losses to offset gains of the same security.
[2:08] The rule states that the investor wishing
to harvest losses cannot buy a “substantially
[2:13] identical” security within 30 days on either
side of the sale, as doing so would trigger
[2:18] a “wash sale” which invalidates the harvesting
of the loss.
[2:22] This rule applies across all your investment
accounts holistically.
[2:25] It also applies to reinvested dividends and
capital gains distributions, so if you’re
[2:31] wanting to harvest losses, you’d want to
turn that off.
[2:33] After you sell to harvest a loss, you can
then either buy a substitute fund immediately,
[2:38] or hold cash for 31 days and then buy your
position in the original fund again.
[2:43] While a bit more complicated, the former may
be the more prudent move, because we know
[2:47] only a handful of great days for the stock
market account for much of each year’s performance,
[2:53] and those days could very well occur during
that 31 day period.
[2:57] But of course, in true IRS fashion, they have
never explicitly defined what constitutes
[3:02] a “substantially identical” security,
so as you can imagine, there exists reasonable
[3:07] disagreement on whether or not two funds from
two different providers that track the same
[3:11] index would be considered “substantially
identical.”
[3:14] Luckily, we can usually avoid that anyway
by just using different indexes to capture
[3:19] the same exposure we’re after.
[3:21] Also remember that tax loss harvesting is
only possible in taxable brokerage accounts,
[3:25] as the IRS does not tax growth in retirement
accounts in the U.S. Thus, if you don’t
[3:30] have a taxable account, you don’t need to
worry about tax loss harvesting at all.
[3:33] Now let’s check out some examples to see
tax loss harvesting in action.
[3:37] The numbers for gains and losses are made
up.
[3:40] The tax brackets and harvesting limits are
real but are subject to change.
[3:44] Consult your tax professional.
[3:45] I’ve included the cursory math on the screen
for each example.
[3:49] First let’s look at an example of offsetting
realized capital gains with a harvested loss
[3:53] to simply reduce the capital gains tax liability.
[3:56] Suppose Sarah has sold a position during the
year for a realized short-term capital gain
[4:01] of $2,000 and is in the 24% tax bracket.
[4:04] Since short-term capital gains are taxed at
her marginal tax rate, she is expecting to
[4:08] pay $480 in taxes on those gains at tax time.
[4:12] Before the end of the year, she notices another
position with an unrealized loss of $1,500.
[4:17] By harvesting that loss, she can now offset
those $2,000 in gains with it, so her short-term
[4:22] capital gain is reduced to $500, on which
she’ll now only pay $120 in taxes, a reduction
[4:29] of 75%.
[4:30] Remember short-term capital gains apply to
positions sold within a year, after which
[4:34] they’re characterized as long-term capital
gains.
[4:37] Long-term capital gains are taxed at lower
rates.
[4:39] Specifically, if Sarah’s previous position
were a long-term capital gain, she would owe
[4:43] 15% in taxes on it instead of 24%.
[4:46] If she deployed the same tax loss harvesting
strategy, she would have reduced her capital
[4:50] gains tax liability from $300 to $75, a reduction
of 60%.
[4:55] This illustrates that tax loss harvesting
is more impactful for short-term gains, but
[4:59] is still useful for long-term gains as well.
[5:02] Now let’s look at an example where the net
loss is equal to the net gain.
[5:06] Assume Ashley has sold a position during the
year for a realized long-term capital gain
[5:10] of $2,000 and later notices before the end
of the year that she has an unrealized loss
[5:15] of the same amount, $2,000.
[5:18] Harvesting the loss offsets the gain in full
so she now has zero capital gains tax liability
[5:23] for the year.
[5:24] For the next example, we’ll look at a situation
where the net loss is greater than the net
[5:29] gain.
[5:30] Assume Ashley’s unrealized loss from the
previous example is now greater at $3,000
[5:35] and she still has the realized long-term gain
of $2,000.
[5:38] She can offset that gain in full and then
use the remaining $1,000 loss to directly
[5:44] reduce her taxable income.
[5:46] If her long-term capital gains rate and effective
tax rate are both 15%, she has saved $300
[5:51] in capital gains taxes and $150 in income
taxes for a total tax savings of $450.
[5:57] Lastly, we’ll look at an example with a
large loss greater than the income-offset
[6:03] limit and zero realized gains.
[6:05] If you subscribe to the Boglehead philosophy
that I preach throughout this site, this is
[6:09] the most likely situation you’ll find yourself
in out of these examples.
[6:14] Pretend Patrick is a long-term investor who
simply invests a portion of his paycheck into
[6:19] his taxable brokerage account of index funds
regularly and has no intention to sell to
[6:24] realize gains until retirement.
[6:26] While his account value has obviously grown
over the years, he has specific tax lots (specific
[6:32] groups of shares bought earlier in the year)
with unrealized losses totaling $5,000 after
[6:38] markets faltered during the year, and he has
zero realized gains because he has not sold
[6:43] any of his positions.
[6:44] Remember we can use tax loss harvesting to
offset income up to $3,000 per year, so Patrick
[6:50] can book that $5,000 loss, reduce his taxable
income for the year by $3,000, and then carry
[6:56] forward that extra $2,000 in unused losses
to use next year or sometime in the future.
[7:02] I’ve seen many ask if tax loss harvesting
is “worth it” when considering the extra
[7:07] time and effort required, to which I’d reply:
[7:10] First, it’s a very small amount of time
and effort required to harvest losses each
[7:14] year.
[7:15] Secondly, yes a $3,000 tax write-off each
year would obviously be valuable to many.
[7:20] Lastly, we showed earlier how tax loss harvesting
becomes increasingly impactful as one’s
[7:26] marginal tax rate increases.
[7:27] A study from First Quadrant estimated that
tax loss harvesting adds about 14% to the
[7:33] final portfolio value compared to one that
does not harvest losses annually.
[7:37] For a $1 million portfolio, that would be
an extra $140,000.
[7:42] So it sounds like tax loss harvesting is always
gravy all the time, right?
[7:46] Well, not quite.
[7:48] Recognize that in selling at a loss and re-entering
the position at the current price, you have
[7:52] now lowered your cost basis from what it was
previously, which means greater gains to be
[7:57] taxed later in the future.
[7:58] Granted, those greater gains won’t be taxed
until you sell, so you’re basically giving
[8:02] yourself an interest-free loan, and we’d
assume a lower tax bracket in retirement with
[8:07] little to no income for most people.
[8:09] But in that sense, it’s important to note
that you have simply deferred taxes; you have
[8:14] not avoided them entirely.
[8:15] So an obvious situation when it would not
make sense to tax loss harvest is if you wouldn’t
[8:20] be taxed on gains in the first place, which
would happen when your income is low enough
[8:25] to avoid capital gains taxes altogether.
[8:28] This only applies to long-term capital gains,
which, at the time of this video, you would
[8:32] avoid if your annual income is below about
$40k.
[8:37] Now let's look at the steps for how to tax
loss harvest.
[8:40] 1 - Turn off dividend reinvestment.
[8:42] Make sure you haven’t bought any shares
of the fund you intend to TLH in the past
[8:46] 30 days.
[8:47] 2 - Sell the position at a loss.
[8:49] 3 - Buy an alternative replacement fund (examples
below) or hold cash for 31 days and then re-enter
[8:54] the original position.
[8:56] 4 - Turn dividend reinvestment back on unless
you plan to TLH more throughout the year.
[9:01] Here is a non-exhaustive list of groups of
alternative index funds that you can swap
[9:06] out that we can be sure would not be classified
as “substantially identical.”
[9:11] I'm not going to go through them one by one
so you can pause the video here or visit the
[9:15] link in the description to sift through this
list.
[9:18] In conclusion, tax loss harvesting – selling
losing positions to offset gains and/or reduce
[9:24] taxable income – may be a useful part of
your investing strategy.
[9:27] The tax savings from harvesting losses increase
as one’s marginal tax rate increases.
[9:33] Plan ahead to ensure your tax loss harvesting
tactics go smoothly.
[9:37] Follow the steps above and decide whether
or not to buy a substitute fund or hold cash
[9:42] for 31 days.
[9:43] For those using M1 Finance, note that while
the broker does not specifically automatically
[9:48] harvest tax losses for you, their tax optimization
selling algorithm does sell tax lots with
[9:53] losses first anytime you sell shares.
[9:56] How do you approach tax loss harvesting in
your portfolio?
[9:59] Let me know in the comments.
[10:01] Thanks for watching.