Tax-Loss harvesting has been given a spotlight in 2020, thanks to a massive market correction earlier this year. It's never enjoyable for investors when the stock market goes down; however, market declines present a couple of beneficial opportunities. For one, it allows long-term investors to buy stocks at a discount compared to their previous highs. Additionally, it offers certain investors the ability to reduce their tax liability via a strategy called tax-loss harvesting. So how exactly does tax-loss harvesting work?
We discussed tax-loss harvesting in-depth in a recent podcast episode. I encourage you to subscribe to Financial Clarity for Doctors and listen to it. Today we will walk through a tax-loss harvesting guide and discuss the pros and cons of tax-loss harvesting to help you answer the question, "Is tax-loss harvesting worth it?"
What is Tax-Loss Harvesting?
What is tax-loss harvesting, and how does tax-loss harvesting work? Any time you earn money from active income or your investments, you have to pay taxes on your earnings. There are a few exceptions to that, but in general, if you make money, you have to pay taxes.
Well, if you lose money, you can use your losses to offset earnings elsewhere and negate the taxes owed on those other earnings. Nobody wants to lose money, but doing so allows you to lower your tax bill.
Tax-loss harvesting is the process of selling investments for less than you originally paid to offset taxable gains elsewhere. This only works in taxable accounts. In tax-sheltered accounts, such as 401k's and IRA's, this isn't applicable (because you don't pay taxes on investment earnings within tax-sheltered accounts).
The concept of tax-loss harvesting is pretty simple: sell the losers in your portfolio to minimize taxes. The execution of it can be tricky.
Losses offset gains. Short-term losses offset short-term gains, and long-term losses offset long-term gains. Short-term applies to positions held for less than a year. Long-term is positions held for more than a year. The net short-term gains/losses are then compared to the net long-term gains/losses to offset each other. If there is a net loss for the year, up to $3,000 of investment losses can be deducted from your other taxable income for the year. Any amount beyond that can be carried forward and used to offset taxable gains/income in future years until the losses are exhausted.
Tax-Loss Harvesting Guide
As mentioned in the previous section, the first step is to sell the losers in your portfolio. This is easier said than done. The simple example is if you own a stock or a mutual fund where all of the shares were acquired in a single purchase. In that scenario, you have a single cost basis for your shares. The cost basis is the amount you paid for something. For example, if you purchase 100 shares of XYZ stock at $50 a share, your cost basis is $50/share or $5,000 for the entire position. If the share price drops to $35/share, you can sell the whole position for $3,500 for a total loss of $1,500 dollars. That $1,500 loss will offset realized gains of $1,500 elsewhere in your portfolio that you otherwise would owe taxes on.
What if you are making regular contributions every month to your investment portfolio? This is where things get a little more complex. In this scenario, you have to look at the individual tax lots. Each purchase establishes its own tax lot. You may have purchased XYZ stock at various prices ranging from $20/share up to $60/share over the last decade. If the price is currently at $35/share, any tax lots above $35/share would be sitting at a loss. Any tax lots below $35/share would still be at a taxable gain if sold. So what do you do here?
If the goal is only to realize losses and not realize gains, you only want to sell the losers. Therefore, you have to hand-select the individual tax lots you wish to sell and only sell the losers to realize those losses.
If you prefer to get rid of all of your XYZ stock, you could sell the entire position, knowing some of the shares are at a gain, and some are at a loss. The losses will offset the gains dollar for dollar. If the net result is a gain, you will owe some taxes on the total gain. If the net result is a loss, you can use the net loss to offset taxable gains elsewhere in the portfolio.
What Do You Do with The Proceeds?
After selling positions in your portfolio, you will have some cash available. Assuming your investment goals and strategy have not coincidentally changed at the same time you are tax-loss harvesting, it is imperative to reinvest the money immediately, ideally in similar positions as before.
For example, if you sell a mutual fund that invests in large US companies, reinvest the proceeds in a different mutual fund that invests in large US companies. (I'll explain why it needs to be different in a minute). The goal is to maintain your overall investment allocation deemed appropriate for your goals. Tax-loss harvesting is strictly an allowable means to lower your taxes. That's it. It shouldn't alter your portfolio composition or strategy. So, be sure to reinvest the money immediately into your pre-determined asset allocation so your investments can continue working towards your goals.
Beware of Wash Sales
Wash sales are why you need to reinvest your proceeds in something different than you just sold. If you sell XYZ stock at a loss and then purchase new shares of XYZ stock within 30 days, it is considered a "wash sale," and the losses' tax benefits are negated. Therefore, if you sell a position, you must wait at least a month before purchasing that position again.
This applies across all of your accounts. If you have a Roth IRA and a taxable account, you can't purchase new XYZ stock shares in your Roth IRA within 30 days, either. Many of you have similar holdings in all of your investment accounts, so it's crucial to pay attention to this when tax-loss harvesting.
How do you immediately reinvest the money then in a similar asset allocation if you can't reinvest in the same stuff for at least 30 days? It's not that hard. The individual position you own matters far less than the overall asset class.
Sticking with one of the previous examples using large US companies, if you sell an S&P 500 index fund, you could reinvest in a Russell 1000 index fund. Both invest predominately in large US companies, but they track different indices, so they are different enough to avoid the wash sale.
Pros and Cons of Tax Loss Harvesting
There are multiple pros and cons of tax-loss harvesting. The big attraction to it is lowering taxes. Who doesn't want to reduce their tax bill? It also creates an opportunity to rebalance your portfolio with minimal tax implications.
Rebalancing is the process of periodically adjusting your portfolio back to its initial target allocations. For simplicity, let's pretend your target investment portfolio is 50% US stocks and 50% international stocks. Hypothetically, if US stocks increase more this year than international stocks, you may end the year with 60% of your portfolio in US stocks and 40% in international stocks. To rebalance the portfolio, you would sell 10% of the US stocks to bring the position back down to 50% and reinvest that money in international stocks to bring that position back up to 50%. This forces you to sell high, buy low, and maintain a consistent portfolio strategy over time.
The problem with rebalancing is that it is the opposite of tax-loss harvesting. Tax-loss harvesting involves selling the losers, whereas rebalancing consists of selling the winners and buying the losers. Well, tax-loss harvesting helps offset the tax ramifications of rebalancing.
The other advantage of tax-loss harvesting is you are deferring many of your gains, so you pay taxes on them when you withdraw money from your portfolio in retirement, rather than while you are working. In retirement, you are theoretically going to be in a lower tax bracket than your working years, so the tax implications then should be (hopefully) softer than at your peak earning years.
The downside of tax-loss harvesting is mostly the effort involved. You have to pay attention and be proactive. Yuck. Sounds like work. It is like doing yard maintenance to keep your grass green and weed-free. It's a lot easier not to mow your lawn and not weed the yard. That takes time and effort. Time + effort = no fun. It might make sense to hire a financial advisor to do the portfolio maintenance for you 😉.
Also, the other downside to wash sales is your portfolio could get more complicated the more you tax-loss harvest. Before you know it, you could end up with four large-cap US funds, three small-cap funds, five international positions, all from trying to avoid wash sales, and invest in something similar but not identical. At some point, you may choose to sell some winners to simplify things.
Is Tax-Loss Harvesting Worth It?
Is tax-loss harvesting worth it? In short, absolutely. Take March of 2020, for example. Stocks across the board dropped on average by about 35% in four weeks. They have since rebounded, and US stocks are sitting at all-time highs at the time of this writing in late August 2020. Someone who did tax-loss harvesting in their portfolio in late March and reinvested immediately could have tens of thousands of dollars (or more) of paper losses that can offset taxable gains elsewhere. That will save them thousands of dollars in taxes this year (and potentially next year). An identical person who didn't tax-loss harvest their portfolio would have the same portfolio balance today but will end up paying more in taxes in April when taxes are due.
Now, you have to weigh the number of losses you can realize in relation to the effort involved and the portfolio composition ramifications if you have a $100 loss, probably not worth it. Suppose it's a $100,000 loss, definitely worth it.
The tax code is a guidebook for people to maximize wealth and minimize taxes. Take advantage of the provisions available to you. Tax-loss harvesting is an easy one for people to potentially lower their taxes.
Tax-loss harvesting and portfolio rebalancing do not guarantee better investment results. Investing involves the risk of loss, including total loss of principal. Consult with your financial advisor and tax advisor for implications pertaining to your specific circumstances.