How to Legally Reduce Your Tax Bill with Tax-Loss Harvesting

Posted by Alex Frey (@alexhfrey )

Investing in a tax deferred account is always optimal, but it's not always possible. There's only so much money you can put into them every year, and even if you aren't maxing out your IRA and 401(k), it usually makes sense to have open an account that you can access before you retire. At its essence, tax-loss harvesting is a way to make a taxable account act a little like a tax-deferred account. 

What Tax-Loss Harvesting Is

Before getting into the mechanics of how this works, it is useful to review the math of why deferring taxes is advantageous.  Let's say you hold some investments that you are able to grow at 10% a year on average (the historical rate of return of the stock market). Suppose you hold them for 35 years until you retire. Using the "law of 72" we can quickly calculate that your investments will double in value approximately every 7 years (72 divided by 10 is about 7). Since there are five seven year periods in thirty-five years, this means that your investment will double five times over the course of your holding period. Of course an investment that doubles in value five times will go up far more than ten times in value (5 x 2), it will actually go up 32 times in value (2 x 2 x 2 x 2 x 2). 

Now let's say that you have to pay 40% taxes on your investment gains every year. This would reduce your annual after-tax rate of increase from 10% to 6%. If you didn't know anything about the way that compound arithmetic works, you might think that this would effect your final wealth by only 140% of your initial investment (the 4% difference times 35 years). If that was the case, your new investment would go up in value a still respectable 30.6 times. But of course this is not right. Using the law of 72 we can find that your new investment will double in value only every twelve years (72 / 12 = 6). So over the course of 35 years it will double about three times, going up 8 times in value overall (2 x 2 x 2). 

So an investor that is able to earn 10% returns will actually end up four times as wealthy as an investor that is only able to earn 6% returns. What is important about that is this: even if the investor has to pay taxes at the end of the period, he or she will still come out ahead investing in the tax-deferred account.

The cleanest way to avoid this brake on your returns from taxes is to maximize the use of retirement accounts like the IRA and the 401 (k). All investments in these accounts are completely tax-free. 

But even a taxable account can be managed in a way that minimizes the huge impact that taxes can have on wealth. The most basic (but often neglected) way to do this is simply to avoid selling positions that have a taxable gain associated with them, since you only owe these taxes when you actually realize the gains.

A more advanced way to defer paying taxes is to actively sell positions in which you have a loss. These "tax losses" can be used to offset any realized gains that you may incur through natural re-balancing. This is what is meant by "tax-loss harvesting."

How to Do It

Two practical difficulties must be addressed to put a tax-loss harvesting strategy into practice: 1) When do you do it, 2) What do you re-invest sales into?

There's no perfect "trick" for when to do it, but reasonable approaches are based on time of the year, investment holding period, and size of loss, or ideally a combination of the three.

At the end of the calendar year is a good time to go through your portfolio and scan for any losses you might want to realize, since you will be able to take these on your taxes that are due in a few short months.

Another good time to take a loss on an investment is 364 days after you bought it. That's because if you take a loss before reaching the one year holding period, you can take it against any short-term gains that you might have (which are taxed at the ordinary income rate). If you wait longer than a year, it becomes a long-term capital loss which "counts against" any long-term capital gains that you may have.

Finally, if you have a loss that reaches some pre-set size that you determine is significant based on your own financial circumstances, you might decide to go ahead and take it. 

Once you have taken a loss, the question becomes what to re-invest the money from the sale into. The ideal strategy from an investment perspective would often be to buy back the very same investment that you sold, since you presumably sold it for a tax reason, not for an investment reason. This would allow you to get the tax advantage of the sale while not impacting your asset allocation. Unfortunately, the IRS has a strict rule against doing this. The "wash sale" rule stipulates that you must wait at least 30 days prior to re-purchasing an identical security. It is risky to sit on the sidelines this long, since the market could go up a lot in the mean time. If you are using ETFs, a better strategy is to immediately purchase a security that is "similar, but not identical" to the security that you sold. Because most mainstream ETFs closely track an asset class, there are usually plenty of good choices. The following table shows a few of them:

Asset Class Primary ETF First Substitute Second Substitute
International, Developed Markets VEA GWL SCHF
Emerging Markets Equities VWO SCHE EEM
Bonds (all) BND SCHZ LAG
Commodities DBC DJP GSG
Gold GLD DGL  
Global Real Estate VNQI RWO  

Switching from, say, the Vanguard US Stock ETF to the Schwab US Stock ETF is unlikely to make much of a difference towards your future returns, but most tax professionals seem to agree that these securities are "different" enough that they allow you to realize your tax losses under the wash sale rule.

*NOTE: The IRS is a bit unclear about how "different" securities have to be for you to take your tax-loss, but most in the industry assume that ETFs that track slightly different indices of the same asset class should count. We are not tax professionals, so we're just going with the consensus. But you should do your own research.

A Caveat - One Scenario Where You Might Want To Harvest Gains and Not Losses

Alert readers have probably already picked up that there is a bit of a "catch" to tax-loss harvesting that we danced around just a bit above. When you harvest losses, you will be lowering your future tax basis, which will increase the amount of taxes you may have to pay in the future. This actually isn't really a "catch", because as the first example showed, there is still a tremendous value to deferring taxes even when you have to pay them later. Also, almost everyone pays a higher tax on income than on capital-gains, and the IRS lets you use up to $3000 in investment losses to offset your earned income. So it's (almost) always advantageous to tradeoff lower income today for higher capital-gains tomorrow.

But one case where tax-loss harvesting may not make sense is if you will be using your losses to offset long-term capital gains, you are in a low capital-gains bracket today, and you expect to be in a much higher one in the future. In this case, it might actually make more sense for you to harvest gains -- to take them while you are in a low tax-bracket and reset your cost basis so you won't have to take them later. There are a few situations where this can arise:

  • Some or all of your capital gains may be taxed at 0% if you are in the 10 or 15% income-tax bracket. In this case, you might as well take any long-term capital gains you have and reset the cost basis. 
  • You might be in the 15% bracket now but anticipate that taxes on capital gains are going to be much higher in the future (possibly due to a combination of your own income increasing, and tax rates increasing due to ongoing budget problems). In this case, harvesting losses might not make much sense, apart from the $3,000 you can deduct from short-term income.
  • Obviously if you are paying no income-tax, deducting $3000 from your income might not be helpful.

Most investors will likely not fall into one of these categories, but it's worth pondering for a second whether you do before you hit the sell button. 

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By Alex Frey