Is Tax-Loss Harvesting Worth it? | The Ultimate Guide

What is tax-loss harvesting?

In its purest form, tax-loss harvesting is designed to save you money on your realized taxes today, and possibly in the future. Tax-loss harvesting applies only to investments owned within taxable accounts, not retirement accounts like 401(k)s or IRAs. It requires a little bit of work, but the potential can be large enough to make it worth the effort. Saavy Man Tax Loss Harvesting

Does tax-loss harvesting work?

This post will arm you with the information to decide whether tax-loss harvesting makes sense for you. You’ll understand the definition of tax-loss harvesting and what it’s designed to do.

To properly handle this topic, you need to understand how stocks are taxed and how funds are taxed. The tax-loss harvesting rules will be outlined so that you can determine whether tax-loss harvesting is a good idea for you.  

To be able to perform the money-saving tax-loss harvesting, there’s a lot to understand. So, if you’re not the do-it-yourself type, then consider hiring a financial professional who will take care of this and other financial management tasks.

The Fundamentals of Tax-Loss Harvesting

How are stocks taxed?

When you sell a stock, bond, or fund for a profit, you’ll need to pay capital gains tax to the IRS. If you own a mutual fund and the fund manager sells assets held within the fund, you’ll pay tax on the gains, even if you don’t sell your shares. These are called capital gains distributions.

“What Is a Capital Gains Distribution?

capital gains distribution is a payment by a mutual fund or an exchange-traded fund (ETF) of a portion of the proceeds from the fund’s sales of stocks and other assets. It is the investor’s share of the proceeds from the fund’s transactions.” ~Investopedia

Understanding Mutual and Exchange Traded Fund Capital Gains

After the year is over, you receive a tax form or 1099, which lists the exact amount of the long- and short-term capital gains distributions from each mutual or exchange-traded fund. Yet, for tax-loss harvesting, you need this information before year-end.

To approximate the amount of capital gains distributions on your mutual fund or exchange-traded fund, go to the investment fund’s website. 

For example, Fidelity has a page entitled “Distributions by Fidelity Mutual Funds,” where investors can see the per share distributions by a specific date. Using this information, investors can estimate the annual capital gains expected. These capital gains are paid to you whether you sell shares or not. 

Is Tax-loss Harvesting Worth It? | The Ultimate Guide

Understanding Individual Stock and Bond Capital Gains

For individual stocks or bonds, the fund company will provide the net sale proceeds, but you must calculate the asset’s cost basis to determine what the true cost of the asset. This is usually an adjusted amount, not just the price you orignally purchased it for, which includes commissions and dividends received.

To find the basis when selling an individual stock or bond, list the cost of your purchase plus any commission you paid. Next, add in the value of any dividends received. This gives you an adjusted basis. Calculate the capital gain (or loss) by subtracting the sale proceeds from the basis.

If the investment is owned for one year or less, the gain is considered a short-term gain. These capital gains are taxed as ordinary income. Your ordinary income tax rate depends upon your income tax bracket.

If the investment is owned for longer than one year, the gain is a long-term gain. These capital gains enjoy lower tax rates, either 15% or 20%.

After calculating an estimate of net short-term gains and net long-term gains, you’re ready to craft the tax-loss harvesting strategy.

2019 Income and Capital Gains Tax Rates

These tax tables can help explain the tax offset benefit of tax-loss harvesting.

With tax-loss harvesting, since short-term gains are taxed at the ordinary income rate, someone in the 24% income tax bracket will keep nearly a quarter of their short-term profits, which would have been paid to Uncle Sam.

Income Tax Rates 2019

Is Tax-loss Harvesting Worth It? | The Ultimate Guide

Capital Gains Tax Rates 2019

Is Tax-loss Harvesting Worth It? | The Ultimate Guide

Tax Consequences of Selling Stock

When you sell stocks, bonds, or funds that haven’t worked out as planned, you lose money. But you can recoup part of the loss, with tax-loss harvesting.

For example, let’s assume that you purchased $10,000 worth of the SPDR S&P 500 ETF (SPY) in January. Then, the market falls in October and your $10,000 SPY investment declines by -10%. Your investment is now worth only $9,000. If you sell SPY at that point in time, you will have a $1,000 loss. (Calculate the basis, the same way you would for a gain.)

Despite the pain of losing $1,000, the silver lining is the tax-loss harvesting. You can use the $1,000 loss to reduce your taxes.

How Does Tax-Loss Harvesting Work?

With tax-loss harvesting, you can use the capital loss to offset capital gains. If you don’t have any capital gains, you can use the $1,000 loss to offset $3,000 of ordinary income.

Tax Loss Harvesting Rules

There’s more to tax-loss harvesting than simply applying losses to gains. There are specific rules to follow.

How to use tax losses:

1. First, short term losses must be used to offset short term gains.

2. If you don’t have any short-term gains, you can use short-term losses to offset long-term gains.

3. If you don’t have any short- or long-term gains, then you can use the short-term losses to offset up to $3,000 of ordinary income.

4. If you have a loss greater than $3,000 remaining, it can be carried over into subsequent years and used to offset capital gains and/or ordinary income in the future. This is called the capital loss carryover or capital loss carry forward rule.

5. For long-term losses, the same sequence applies. Use long-term losses to offset long -term gains or short-term gains if you have no long-term gains. The remaining losses can be used to offset $3,000 of ordinary income.

Ultimately, net losses of either kind can be deducted against the other type of gain. Any remaining losses not used to offset capital gains can also be used. $3,000 can offset ordinary income with the remaining losses used to reduce taxes in future years. Although, if you use the married filing separate status, the net capital loss used to offset ordinary income is capped at $1,500.

The Wash Sale Rule

The IRS will not allow loss sellers to purchase the same or substantially identical security within 30 days before or after the sale or the loss will be disallowed. This is called the wash sale rule.

Since it’s important for investors to maintain their preferred asset allocation, there is a solution to the wash sale rule. To remain invested in a similar asset class, you need to carefully select the security to buy, to avoid running afoul of the wash sale rule.

After selling for a loss, investors can find a related stock or fund to purchase within the 30-day window, one that is not the same or substantially identical. This is a very important concept that must not be ignored. 

ALLOWED: For example, if you sold SPDR S&P 500 ETF (SPY), which is an index fund that invests in the companies represented by the S&P 500, you can reinvest the proceeds in the Vanguard Total Stock Market ETF (VTI). This is an exchange-traded fund that invests in a representative sample of the total US stock market, including large-, mid- and small-capitalization stocks. In contrast, SPY owns mainly large-capitalization stocks that belong to the S&P 500 stock market index.

NOT ALLOWED: If you sold SPDR S&P 500 ETF (SPY) and you immediately (within the 30 day window) purchase iShares CoreS&P 500 (IVV), you would be purchasing a substantially identical position, violating the Wash Sale Rule.  However, outside the 30-day window of the sale of the losing security, you’re free to buy the same asset, with no adverse consequences.

Tax Loss Harvesting Example

Is Tax-loss Harvesting Worth It? | The Ultimate Guide
Image credit: https://www.morganstanley.com/articles/tax-loss-harvesting

Tax Loss Harvesting Example 1

Jenna has a gain of $30,000 on Fund A. She sells the Fund for a gain taxable gain of $30,000. 

She notices that Fund B is down $15,000 since she bought it.

Instead of waiting for Fund B to rebound (or not), she decides to sell Fund B for a $15,000 loss.

She harvested the $15,000 loss from the sale of Fund B to offset the $30,000 gain on the sale of Fund A.

With tax-loss harvesting, her tax bill is $2,250 or 15% of the $15,000 gain.

Without selling the losing Fund B, her tax on the $30,000 gain is $4,500.

To keep her asset allocation constant, she bought a similar, although not identical fund, to replace Fund B.

The net impact of tax-loss harvesting was to reduce the amount of federal income tax paid while keeping a constant asset allocation.

Tax Loss Harvesting Example 2

Justin has a gain of $30,000 of Fund A. He sells the Fund for a taxable gain of $30,000.

He also has a loss of $33,000 from the sale of Fund B.

With no other capital gains than the $30,000, he can use the $33,000 loss from the sale of Fund B to offset the total $30,000 gain of Fund A and also to offset $3,000 of ordinary income.

This further reduces Justin’s tax bill.

When Tax-Loss Harvesting Doesn’t Make sense

Tax-loss harvesting shouldn’t take precedence over the investment plan. In practice, in order to stick to the pre-determined asset allocation, make sure to reinvest the tax-loss harvesting proceeds into a similar, although not identical, security. Of course, after 31 days, you can reinvest into the original asset.

If you’re in the zero capital gains tax bracket, you might be better off accepting the gain, unless your loss is significant enough to offset a portion of ordinary income.

If the loss is from an asset owned in a tax-advantaged retirement account, tax-loss harvesting doesn’t make sense. All assets owned within an IRA or retirement account aren’t taxed. (Except when you withdraw assets from a traditional IRA or 401(k) account.)

Is Tax-Loss Harvesting Worth it?

In most cases, the answer is a resounding yes. By reducing the taxes that you pay, while maintaining your portfolios asset allocation, you’re essentially increasing your overall investment return. This is especially true if you offset short term gains, which are taxed at the ordinary income rate and not the lower capital gains tax rate.

However, as mentioned earlier, you should NOT be taking advantage of the tax-loss harvesting rule if it forces you to abandon your long-term investment plan.

The key is to make sure to maintain your asset allocation and reinvest the proceeds of the sale in another investment that is somewhat distinct from the one you sold. This will keep you from falling prey to the wash sale rule, which will disallow the loss!

To learn more about how the IRS looks at the tax treatment of capital gains and losses, go to their website.

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