How to limit market losses through tax loss harvesting
Sour periods are an inevitability with investing, but there is an opportunity to make lemonade out of those lemons through tax loss harvesting. In short, tax loss harvesting allows you to harvest tax savings from losses incurred from your investments, without sidetracking your overall investment strategy.
What is Tax Loss Harvesting?
As you are probably aware, the IRS taxes capital gains on the value of stocks and other securities (among other capital assets).
The capital gain is the amount of profit you made on the purchase and sale transaction. For example, if you bought ABC stock for $100 and sold it for $120, your capital gain is $20.
The IRS would then require you to pay a capital gains tax on that $20. How much depends on your income tax bracket.
Capital gains tax brackets for 2023 are as follows:
| CAPITAL GAINS 2023 (Long-Term Gains) | ||||
| Tax Rate | Income Level Single | Income Level Married Filing Jointly | Income Level Married Filing Separately | Income Level Head of Household |
| 0% | $0 – $44,625 | $0 – $89,250 | $0 – $44,625 | $0 – $59,750 |
| 15% | $44,625 – $492,300 | $89,250 – $553,850 | $44,625 – $276,900 | $59,750 -$523,050 |
| 20% | $492,300 or more | $553,850 or more | $276,9000 or more | $523,050 or more |
The brackets above are long-term capital gains which are characterized as any capital gain received after owning the asset for at least one calendar year.
Capital gains on assets owned less than one year are known as short-term capital gains and are taxed at your normal income tax rate.
The differing tax rates are designed to incentivize you to hold assets for longer periods as opposed to turning them over for a quick profit.
The opposite of a capital gain is, as you might guess, a capital loss. The IRS allows you to offset capital gains using capital losses.
Tax loss harvesting is a strategy through which one intentionally sells a capital asset at a loss in order to harvest the ability to offset capital gains in the same amount.
It sounds simple, but there are some rules the IRS has for these transactions which we’ll cover in more detail below.
How and When to Tax Loss Harvest?
First off, you can only tax loss harvest from assets that are owned in a taxable space.
It doesn’t make any sense to try and harvest losses within a retirement account because the tax has either already been paid (Roth) or isn’t due until withdrawals are made (traditional or tax-deferred).
Next, you should evaluate exactly how much loss you have available to tax loss harvest. Odds are your brokerage will show you which investments are currently trading at a gain or loss.
To calculate it yourself, simply multiply the number of shares you own times the current market price. Then subtract your costs basis, which is the price you paid when you bought the asset times the number of shares you own.
If your cost basis is higher than the current market value of the shares, then you have a tax loss harvesting opportunity.
Finally, you need to know your capital gain tax rate which we already posted above. This percentage of the loss is what you’ll actually save if you elect to sell below your cost basis.
If your capital gains tax rate is 0%, then you too can ignore this strategy because you won’t have any capital gains tax to offset. This strategy is most beneficial to taxpayers in higher brackets
Why Take a 100% Loss for a 15% Tax Savings?
Those of you who are mathematically astute may quickly note that it doesn’t make much sense to take a 100% capital loss in order to save 15% in taxes (or whatever your capital gains tax rate is).
I couldn’t agree more.
But the loss only remains a loss if you keep the funds from the sale in cash.
When we tax loss harvest, we’re going to immediately repurchase similar, but not “substantially identical”, investment instruments. (More on that in a minute.)
This way, we avoid getting ourselves in a market timing situation and we effectively never really leave the market or our investing strategy, or only do so for a minute or two.
But why would I rebuy on a bad day?
This isn’t a post about market timing, but how do you know it’s going to stay a bad day? How do you know it won’t get worse?
If you try to hold off your repurchase and time the market, you could get burned.
That’s why no matter what, we rebuy a different asset immediately. Market timing is basically a shift from investing to gambling.
There are plenty of gambling websites out there, but this isn’t one of them and market timing is not something we’ll be encouraging.
The Wash Sale Rule
I used the phrase “substantially identical” earlier and now I’d like to explain why.
Once you sell an asset at a loss, the IRS will forbid you to use it to offset gains if you repurchase a substantially identical asset within 30 days or if you bought it 30 days before.
This is known as the wash sale rule.
While the wash sale rule is intended to prevent unethical activity used in more esoteric investing strategies, it still applies to the average Jane or Joe.
To avoid the wash sale rule, investors simply need to buy investments that are not substantially identical to what they’re selling at a loss.
I’m not about to tread into the arena of interpreting what the IRS means by substantially identical. Call your broker, accountant, lawyer, or other tax professionals if you want advice on that.
For me, if I can’t explain how the investments are different, then it doesn’t cut the mustard. Again, if you have any doubts go talk to a pro.
Personal Example
I’m writing this on September 13, 2022.
This morning the Bureau of Labor Statistics reported that the record inflation we’ve seen in recent months hasn’t been stemmed by increasing interest rates.
At least, not yet.
The assumption on Wall Street is this means further interest rate increases by the Federal Reserve Bank and even slower recovery from the current funk the economy is in.
As a result, stocks are down today. Like, way, way down. Like, the biggest single-day drop in over two years.
For context, the Dow Jones fell 3.94% today, the Nasdaq fell 5.16%, and the S&P 500 dropped 4.32%. Ouch.
Days like today aren’t much fun. No one likes watching the value of their investments erode, much less seeing them retreat so much in one day.
So, when days like today come it’s nice to have a little psychological boost by exerting some positive control over your portfolio through tax loss harvesting.
Throughout 2022, Lisa and I have been provided with the opportunity to engage in tax loss harvest several times.
Today, we sold 188 shares of MGK at a loss of $906.13. MGK is a mega-cap growth ETF managed by Vanguard. We own it in our taxable brokerage account because we like large-cap growth stocks.
We also like how this ETF combines diversity in that category with low expenses and relatively efficient dividend yields.
Since we don’t have any capital gains to offset this year, we’ll be using the loss harvest to directly reduce our taxable income.
We’re in the 24% income tax bracket, so this tax loss harvest will net us $217.47 of avoided income tax (24% of $906.13).
Considering we’ve been wanting to move more and more of our portfolio into S&P500 index funds anyway, and it only takes a few minutes to make the trade, $217.47 was worth the time for me to quickly drop MGK and pick up an equal value of shares in VOO (a Vanguard S&P 500 fund).
Also, since VOO is not identical to MGK, the sale steers clear of any wash sale violations, assuming we don’t rebuy MGK before October 14th.
Many will say that $217.47 isn’t worth the time and effort and if you feel the same way you are free to wait for even larger losses before attempting this strategy.
For me, it took about 5 minutes to check our cost basis, calculate the loss, sell the ETF, and buy the new one.
Limitation on Offsets
Here are some other important points to remember regarding tax loss harvesting:
- The IRS limits taxpayers to income deductions of $1,500 per year for singles and $3,000 per year for married couples for capital losses.
- If you realize losses over these limits, they can carry over into future tax years indefinitely.
- Capital gains can be offset dollar-for-dollar by capital losses in a given tax year, without limit. This is especially helpful to remember if you realize a large capital gain in a given year and have stored up losses that can offset the large gain.
- Short-term losses are first used to offset short-term gains and long-term losses are first used to offset long-term gains. After that, any remaining losses can be used to offset either type of gain.
- This makes short-term losses the most valuable to harvest because they are first used to offset short-term gains, which are taxed at a higher income tax rate than the long-term capital gains rate.
Finally, I want to encourage you to avoid allowing this strategy to be the tax tail that wags the investment dog. Don’t let a desire to tax loss harvest take you off the track of your overall investment strategy.
FAQs
What is Tax Loss Harvesting?
Tax loss harvesting is a financial strategy through which one sells securities at a loss in order to harvest the tax deduction for the decrease in value of the asset(s).
How much can I deduct for tax loss harvesting in a year?
You can offset any gains dollar for dollar with tax loss harvesting or you can deduct up to $1,500 single/$3,000 jointly from your taxable income in a single tax year.
Any losses over $1,500/$3,000 can roll over to following years indefinitely until the full value of the loss is claimed.
Isn’t tax loss harvesting market timing?
Yes and no. Yes, in the sense that you must incur a loss and sell the asset while it is trading at a loss, but if you rebuy securities that are not “substantially identical” immediately following the sale then you won’t actually be out of the market for long.
Can I rebuy the same security after I sell it for a loss?
Not if you want to harvest the loss. If you rebuy the same security (or one that is substantially identical) within 30 days then you void the loss and cannot claim it on your taxes.
In what order are the losses deducted from my taxes?
Short-term losses are first used to offset short-term gains and long-term losses are first used to offset long-term gains. After that, any remaining losses can be used to offset either type of gain.
Is tax loss harvesting really worth it?
Tax loss harvesting will reduce your taxable income by whatever amount your loss is. The benefit is that amount multiplied by your marginal tax rate.
So, depending on your tax bracket, tax loss harvesting could save you up to 37% of the amount of your loss.
