Tax-loss harvesting is something I tend to think about after a strong year of equity returns. I find myself asking if I should reduce risk in some names or at least re-balance the portfolio. The problem is that this can create significant capital gains. That said, if you are like me, you probably have some investments that did considerably well this year and some that have done not so well (they generated losses). We can use those poorer performing investments to help offset our capital gains, reduce our taxable income, and even compound our earnings at a better rate, all things being equal.
My goal of this post to provide examples of tax-loss harvesting scenarios that will allow investors to not only understand the concept better, but also save money.
The basics are simple – an investor typically sells a stock or fund that has losses to offset another investment she is selling that will result in a gain. Let’s lay down the tax rules first so we’re all on the same page:
- The long-term capital gain/loss tax rate is typically 15%. However, if you are in the 10-12% tax bracket, your capital gains rate is 0%, but if you are in the 37% bracket, it is taxed at 20%. The analysis herein will assume most people fall in the 15% bracket.
- The short-term capital gain/loss is taxed at your income tax rate. Short-term capital gains can therefore be quite expensive. If you think it is fine to hold out for a year and a day, it might be worth it to do so. However, never let the tax tail wag the dog – if an investment could plummet, its best to take your winnings an move on.
An important thing to lay out in the beginning before we get into examples: short-term capital losses are worth more because they are taxed at the higher rate. That means they are best to apply to your short-term gains or long-term gains, rather than, for example, applying a long-term loss that is taxed at 15% to a short-term gain that could be taxed at 37%.
Example #1: Using capital losses to offset gains
Simple example. You have a $10,000 gain on ABC stock and also a $10,000 loss on XYZ stock. You sell ABC and XYZ to net each other out. Assuming a 15% tax rate, this saved the investor $1,500 (15% x $10k gain). Further, let’s say you take that saved income and earn 5% per year on it over 5 years (i.e. opportunity cost). That means you would also have an extra $414 after 5 years.
Example #2: Repurchasing the sold shares & avoiding wash sales
If we build on Example #1, we should discuss the “wash-sale rule.” This rule prevents someone from selling a stock for a loss for taxes and then immediately buying it back. The IRS requires you to wait 30 days before you can buy it back.
Let’s say the price of XYZ stock is still $90 after we wait 31 days, so we buy it back at the same price we sold. Over the next 5 years, our analysis was correct and it appreciates to $150.
Good outcome, right? We have a $50k gain on our investment, less what we owe in taxes ($7.5k), but also have what we saved in taxes from Example 1.
So are we in a better position? What if we didn’t sell XYZ in the first place?
We would have owed $1,500 in taxes in Example 1 and would not have benefited from the $414 time value of money.
As you can see below, it paid off to take the loss, despite having a bigger taxable gain in 5 years from the sale date.
That said, the total amount saved isn’t really that great. Don’t get me wrong, I would take an extra $414 dollars if it fell from the sky, but there must be a way to improve these results.
Avoiding the wash sale rule
One type of loss that is harder to measure is the loss associated with being out of the market as you wait to buy the security back.
However, you can buy a fund or security that achieves the same goal of that security as long as it is not “substantially identical” to the existing security. For example, you could sell the S&P500 ETF and buy an actively managed large-cap fund and face no issues.
Therefore, you can still be in the market and benefit while you wait.
Example #3: Think Short Term
While I am sure most people here view themselves as somewhat long-term investors, it is important to think short-term when it comes to tax losses.
The tax code says that long-term losses first offset long-term gains and short-term losses offset short-term gains. Anything left over will go to offset other gains.
The LEAST tax efficient thing to do would be to use short-term losses to offset long-term gains. That is because the difference in tax rates can be around 15 percentage points. In other words, I could have used my short-term losses to offset a short-term gain that I owe tax on at a 35% rate. But instead I am using them to offset something I owe tax on at 15% rate.
The table below attempts to show this. I sell AAA for $10k gain and BBB for a $10k loss, saving myself from $2k in taxes. However, BBB was worth $3,500 in taxes, so I missed $1,500 dollars in tax savings.