Oliver S. Berryhill Blogs: DR Podcast 301: A Guide to Tax Loss Harvesting

Tax loss harvesting can be a smart tool for investors. But first, you have to learn how it works. Here’s our easy guide to tax loss harvesting.

Tax loss harvesting is one of the few free lunches in the world of investing. With a little planning, you can reduce or even eliminate your capital gains in any given year. In some cases, you may also get a deduction from ordinary income of up to $3,000.

Note from the editor: In this episode of the podcast, Rob tells us about tax loss harvesting, sometimes abbreviated TLH. Learn how it works, its benefits, its limitations, and how you can use it to defer taxes. We’ll also look at the implications for those who use robo advisors that offer TLH services. If you prefer to read rather than listen, Rob has delved into Tax Loss Harvesting below, so read on.

Capital Losses

The basic concept is simple. Let’s assume you invest $25,000 in an S&P 500 index fund. Following a down market, you sell the investment a year later for $20,000. The result is a loss of $5,000.

The loss can reduce your tax liability in one of three ways:

First, the loss can be used to offset any realized gains during the year. If you had sold a second investment for a $5,000 gain, the loss would offset the gain, eliminating any tax liability.
Second, after gains have been eliminated, any remaining capital losses can be applied to ordinary income up to a maximum annual deduction of $3,000.
Finally, if you still have capital losses after offsetting gains and $3,000 of ordinary income, the losses can be carried forward to future tax years.

Now to some complications.

Wash Sale Rule

There are times when we sell investments at a loss for reasons that have nothing to do with taxes. Perhaps we need the cash and the investment just happens to be down. In other instances we’ve decided to change our investment plan.

With tax loss harvesting, the sale of losing investments is strategic. We are selling specifically for the tax benefits. Enter the wash sale rule.

As defined by our friends at Investopedia:

An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.

In other words, you can’t sell shares of a mutual fund, ETF, or stock at a loss on day one, repurchase the same or “substantially identical” investment the next day, and report the loss on your taxes. There must be a 30-day window both before and after the loss sale.

So what are your options?

Sell and wait 31 days to buy the same or substantially identical investment, or
Sell and buy a similar, but not substantially identical, investment (e.g., sell S&P 500 index fund and buy total stock market index fund)

This is a complicated topic by itself, so consult with your tax advisor if you’re going to enter into such a transaction.

This is where robo advisors provide a valuable service. For those with significant taxable accounts (at least $50,000) Betterment, Wealthfront, and soon WiseBanyan offer automated TLH services (more on this below). And although Personal Capital isn’t a robo advisor, their Wealth Management service also offers tax loss harvesting.

Wash Sale Rule & IRA Accounts

The wash sale rule applies to purchases inside an IRA. If you sell an investment to create a loss in a taxable account and then buy the same or substantially identical investment in an IRA account within the 30-day window, the wash sale rule will wipeout the tax loss.

Here’s the deal–

Section 1091 of the Internal Revenue Code creates the wash sale rule;
It says NOTHING about IRA or 401k accounts;
In 2008, the IRS issued Revenue Ruling 2008-5, concluding that the wash sale rule applies if a loss generating investment is replaced in an IRA;
The ruling says nothing about 401(k) accounts, but the wash sale rule likely applies to purchase in these accounts, too.

You can refer to IRS Pub 550, Investment Income and Expenses (Including Capital Gains and Losses) for more details.

Short vs. Long Term Gains

Long-term capital gains are assets you hold longer than one year. They are subject to long-term capital gains rates, which are generally lower than ordinary tax rates. Short-term gains are assets you hold for less than one year, and are subject to ordinary income tax rates. This makes a strong case for holding capital assets for at least one year.

Long-term losses are first offset against long-term gains. Short-term losses are first offset against short-term gains. If long-term losses exceed long-term gains, they can then be used to offset short-term gains.

For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the $10,000 excess to any short-term gains. (Source: Fidelity Investments Tackle taxes: Got gains or losses?.)

Tax Loss Harvesting Defers Taxes

TLH does not eliminate tax liability, it defers it. It eliminates the liability in the year the tax loss is harvested, but it in turn lowers the tax basis of the replacement investment. When the new investment is later sold at a gain, the harvested loss is then taxed. An example may help to show how this works.

Let’s assume you have a $100,000 investment. A year later you sell it for $90,000 for a $10,000 loss. You use the $90,000 proceeds to buy a similar but not substantially identical investment. Your tax basis in the new investment is now $90,000.

If years later you sell the investment for say $120,000, your taxable gain will be $30,000. The result is you’ll pay capital gains tax on the $30,000 gain, $10,000 of which represented the loss you took years earlier.

It still works to your advantage. Just like a 401(k) defers tax liability until retirement, tax loss harvesting defers taxes until the investment is eventually sold. That deferral of tax liability allows your money to continue work for you, but it doesn’t allow you to avoid the tax forever.

Tax Loss Harvesting and Robo Advisors

Robo advisors add another dimension to TLH. Services such as Betterment and Wealthfront have promoted their automated investment services with the help of tax loss harvesting. They promise to increase your effective returns by harvesting losses on a daily basis. The promised benefits exceed the cost of their services, which I recently compared.

However, recall that purchases inside a retirement account can trigger the wash sale rule. Recall also that robo advisors buy and sell investments inside your account automatically to generate tax losses. Combined, these can cause a real headache.

For example, imagine you use one robo advisor for your taxable account, but have retirement accounts at other firms. This would be common, for example, if you have a 401(k) through your employer, use multiple robo advisors, have separate brokerage accounts, or use accounts at a mutual fund company like Vanguard for IRAs.

Here’s the problem. The robo advisor will sell investments in your taxable account to generate tax losses. These sales can happen daily, and certainly monthly. Within 30 days of these sales, if you purchase the same or substantially identical investment in one of your retirement accounts, you’ll trigger the wash sale rule.

If all of your accounts are with the same robo advisor, they use software to prevent this from happening. If they are not at the same firm, however, great care should be used before activating the TLH service.

Resources:

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Oliver S. Berryhill Blogs

Thursday, September 13, 2018

DR Podcast 301: A Guide to Tax Loss Harvesting