David from Ft. Worth, TX writes:
“Hey Rob, I’ve heard a lot about a strategy called “Tax Loss Harvesting” but am really confused on what it is. Doesn’t it just delay the gains? Why is everyone making a big deal about this? Thanks!”
If executed properly, Tax Loss Harvesting (TLH) is a pretty cool strategy that can be done in taxable investment accounts and can add serious value to your portfolio and overall net worth. Let’s break it down:
- Tax Loss Harvesting can only be done in taxable accounts, such as brokerage accounts. It does not apply in Trad or Roth IRAs, 401ks, 403bs, SEP-IRAs, or 529s, as those are all tax-sheltered accounts.
- The way TLH works is by selling positions in your account that have declined in value (called “realizing a loss”), and replacing these positions with a similar asset. Buying back a similar asset maintains the proper diversification of your portfolio, meaning, it keeps the right amount in each of the 12 core asset classes that FutureAdvisor recommends.
- Let’s take a quick & simple example: Say our algorithm bought $2,000 worth of IEMG (iShares Emerging Markets ETF) in your Fidelity taxable account and then emerging markets fall in value (which they have recently). Now, that IEMG is worth $1,500 and you have a $500 “unrealized loss” on paper. With TLH, our algorithm would sell IEMG, realizing you the $500 loss, and it would rebuy an emerging markets sister fund that is very similar, say VWO for example. (Vanguard’s Emerging Markets Index ETF). Now, you’ve still maintained the proper risk and diversification of your portfolio, but realized a loss that will benefit you greatly this tax year.
- How does that $500 loss help you you’re probably wondering? Realized losses can be used to offset realized gains for the year. We all know that each year some asset classes go up and others go down, which is exactly how you expect a diversified portfolio to behave. So if you have $2,000 in realized gains, you can offset $500 of them and then have only $1,500 of realized gains to report to the IRS. Since many investors are still in the growth phase of their portfolio and therefore don’t have gains to offset, they can offset ordinary income with unrealized losses, which actually works out to be a much better deal. The IRS lets you offset up to $3,000 of ordinary income with losses each year. If you have more than that, you can carry them forward indefinitely to offset income (or gains) in future years.
- Side story: back in the early 2000’s, I lost *a lot* of money with the stock Palm (remember Palm Pilots?) I finally realized a $30,000 loss in 2005 and I carried that forward for many years, offsetting $3,000 from my income each year. At the 28% tax bracket, this increased my refund by $840 each year. In 2009, I got smart on “expense ratios” and I realized a bunch of gains by selling out of some high fee actively managed mutual funds. This triggered about $10,000 in gains, but I was able to offset most of them with the balance of my Palm loss carryforward, so the tax bill wasn’t so bad. I share the story to show precisely how losses and loss carryforwards can help you both in the current year and in the future.
- Since long term capital gains are taxed at 15% for most taxpayers, offsetting them with losses is a 15% savings. But if you use TLH to offset income, you save at your marginal tax bracket, which is 28% for most of our clients.
David also asked about delaying the gains which is very important to understand as well. In my above example with IEMG, your old cost basis before the sale was $2,000. (Cost basis is simply what you paid for the position.) When you sold IEMG and re-bought VWO, your cost basis got “reset” to $1,500. So when you go to sell VWO, your cost basis is lower, meaning you’ll owe more in taxes than if it was $2,000. This is exactly right, but...
There are three distinct advantages to deferring taxes:
- If you using losses to offset income, you get a 28% discount and when you repay it, you only pay taxes at 15% (the long-term capital gains rate). That’s a clear win!
- If you are simply offsetting gains, you get a 15% savings now and repay it years later at 15% as well. That’s also a win because of the time value of money. Say you save $1,000 on your taxes this year with TLH, you’ll owe $1,000 more in taxes when you sell the position eventually. But, you can use that $1,000 in the meantime to invest! That’s why it’s important to put the TLH savings back into your investment portfolio and not spend it.
- Many people combine TLH with an estate strategy or charitable gifting strategy, which is super-smart. You realize the loss and take the tax savings in the current year, then later in life when you pass on, you gift that position to your kids. They receive a “step-up” in basis and that capital gains tax is never paid. Thanks Uncle Sam! (And thanks mom and dad for saving!) Or, you can gift the most appreciated position to your favorite charity instead of cash, and avoid the gain all together.
So while it may sound like you are simply deferring (or delaying) the gains with TLH, now you’ve learned three clear ways to benefit from it.
Some common questions about TLH:
- Why do I have to re-buy a similar asset? Can’t I just rebuy the same asset I sold? It’s not that easy. The IRS has something called the “wash sale rule” which prevents you from rebuying the same asset back within 30 days. Many people think they can just wait the 30 days and then get back in, but we all know how quickly markets can move in either direction and your portfolio would have a very different risk profile if out of an asset class for 30 days.
- Can’t I just do this myself? You can try, but it’s really hard! Our algorithm analyzes your positions every night, checking for TLH opportunities. It factors in your cost basis, any 30 day restrictions on the ETF, and also the impact of short-term capital gains. Even if you made TLH your full-time job, this would be nearly impossible to do as well as a computer can. Plus, you then have to pick sister funds and consider the slight variation in composition in the sister fund and how that impacts the rest of your portfolio. Specifically, even IEMG and VWO, while similar, have different compositions. Our algorithm looks at this and factors it into the rest of your holdings and transactions. Very wealthy investors (those with $5+ million) used to get manual TLH from their advisor every December, but now with technology, our algorithm brings it to folks with as little as $10,000. And, we look for opportunities nightly, something a strictly human advisor simply can’t do for all their clients.
- How much has TLH shown to help returns? Our research has shown TLH provides 0.5% to 1.0% of additional return, for about the first 10 years. After about 10 years, you’ve likely harvested all the losses out of the portfolio and no more opportunities exist. But, most people invest with regular contributions and this allows you to continuously TLH.
- Are there other benefits of TLH? Yes! Imagine “making money” even in a down market. While everyone else is complaining about losing money, you are at least harvesting losses and saving money on taxes. It’s a great feeling to win even when you’re losing :)
Hope that helps answer your question, David.
Want to see how much you could save by implementing TLH in your taxable account? Check out the TLH tab in our app to get a customized report! Also make sure that whomever you hire to TLH looks across all your household accounts and not just the account he or she directly manages. Some online advisors turn off TLH for married couples because their algorithm can’t handle wash sales between accounts. FutureAdvisor has the most sophisticated TLH software because managed clients can link their entire portfolio and their spouse’s, even those accounts not directly managed by us.
Have a question for a future “Ask Rob” post? Email [email protected]; preference will be given to questions that apply to a broad cross-section of the population.