DR Podcast 301: A Guide to Tax Loss Harvesting

Even in a period of economic prosperity, not every investment pays off, and there are bound to be losses. Fortunately, as the saying goes, every cloud has a silver lining and so does every investment.

You may be able to turn your investment losses into tax gains, reducing the impact on your financial health. This concept is known as 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. Well also look at the implications for those who use robo advisors that offer TLH services. If you prefer to read rather than listen, we delve into tax-loss harvesting below, so read on.

Related: Credit Karma Tax Review

What Is Tax-Loss Harvesting?

Briefly, tax-loss harvesting is the selling of securities at a loss to counteract a capital gains tax liability.

Capital gains are the additional money an investor receives after the sale of a security above its original purchase price. A capital loss is the difference between the selling price and the purchase price of a security sold for a loss.

Whenever you make capital gains, the profit is taxable. But if you take a loss on an investment, those losses can be offset against any profit netted from capital gains. The result is you can reduce or eliminate your income tax liability on the capital gains.

A Practical Example

You're an investor, and after a review of your portfolio, you notice your stocks in the tech industry have risen sharply while your stocks in the energy sector have declined in value.

You realize you want to cash in on the rise of your tech stocks and reduce your exposure in anticipation of a market swing. You sell off some of your tech stocks, and now you have a capital gain and a tax liability due on that gain.

This is where tax-loss harvesting comes in handy. If you sell the energy stock in your portfolio that has fallen in value, you can use the loss to reduce the tax you owe on your tech sector gains. This reduces your tax liability.

If the losses you incurred on your energy stocks are greater than the gains you made, the residual amount can offset $3,000 of your taxable income. This is the cap the IRS has set. And if you still have any additional loss left, that amount can be carried forward to offset losses in the subsequent years.

For example, the sale of your tech stocks netted you a gain of $20,000, and you purchased that stock less than a year ago. The time of the purchase is important because short-term capital gains (held for less than a year) are taxed at a rate higher than long-term capital gains (held for over a year).

The sale of your energy stocks netted a loss of $25,000. Tax-loss harvesting would imply that the $25,000 loss would cover the $20,000 gain you made and the remaining amount of $5,000 would offset $3,000 from your ordinary income. The remaining amount of $2,000 is carried forward to subsequent years and can reduce tax liability on capital gains.

Related: Lose Money on a Stock? Don’t Worry, Here’s How it Can Help Your Taxes

How Tax-Loss Harvesting Works

Here are a few applications of how tax-loss works in your favor.

Strategically Offset Losses Against Gains

In the previous example you sold off two investments, the profitable tech stocks and the loss incurring energy stocks, and paid no taxes. However, there is no rule to selling both investments to utilize the benefit of tax-loss harvesting.

The IRS allows individuals to carry forward their losses indefinitely to be utilized at the investor’s discretion. Instead of selling off both positions you could retain your funds and cash them in at a more opportune moment.

How Much Tax-Loss Harvesting Can Save You

The money you’re trying to save in taxes through tax-loss harvesting mainly depends on two factors; your applicable tax rate and the nature of the revenue stream you’re trying to offset.

The IRS taxes the income realized from capital gains, but the rates vary depending on the period the investment was held by you.

Since short terms gains are taxed higher than long-term gains, it makes more sense to offset short-term gains against short-term losses. It also holds for long-term capital gains and uses them to offset long-term losses.

If, however, you incur a loss in one and a profit in another, tax-loss harvesting can still offset the loss. Any remaining amount is carried forward to reduce the taxable income outside the scope of investment revenues.

Taking the first example of tech stocks and energy stocks, let us look through the number you stand to gain from tax-loss harvesting.

Let’s assume you fall in the 35% tax bracket. So, $20,000 was your capital gain offset with a further $3,000 deducted from your ordinary income.

($20,000 + $3,000) * 35% = $8,050

You stand to save $8,050 in total savings from utilizing tax loss harvesting.

Things to Keep in Mind With Tax-Loss Harvesting

The critical aspect to remember for a successful implementation of a tax-loss harvesting strategy is to assess what you own and why you own it, identify investments running a loss and then discard a portion of those investments against capital gains, expected capital gains or even your income.

Keep Reinvesting But be Wary of Wash Sales

After deciding the investments you want to dispose of and offset the loss through tax-loss harvesting, you must decide upon reinvestments. But you must be careful of a rule which applies to tax-loss harvesting called Wash Sale Rule.

Suppose you invest in the same type of stock you sold to realize a loss. You believe the value will rise or that it matches your desired diversification and risk tolerance. The Wash Sale Rule states that your tax-loss harvesting claim will be declared void if you buy back the stock or a contract to buy the stock within 30 days before or after the disposal of the relevant stock.

If you want to keep exposure of the industry in your portfolio, one way to go around the Wash Sale Rule would be to buy stock in a similar company that operates in the same industry and has more or less the same amount of market share. Or you could purchase an exchange-traded fund (ETF) that tracks the relevant sector.

Although some substitutions are allowed and don't violate the Wash Sale Rule, others can still lead to a void claim. This happens when the IRS deems the substitute as substantially identical to the disposed of investment. Consult a tax advisor if you're unsure before making a reinvestment.

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 wipe out 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 purchases in these accounts, too.

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

Don’t Sell Off Simply for the Sake of Realizing a Loss

Investors should remember not to let the tax tail wag the investment dog.

If you have stocks or securities in your portfolio performing below par, don't sell them off immediately to realize a tax loss. Often market swings are fueled by speculation and not economic or financial facts.

That doesn’t mean you keep sitting on a loss-incurring investment hoping for it to increase in value. There’s a thin line between a smart sale and selling due to market pressures to realize a tax loss.

Related: Best Tax Software for Investors

Pros and Cons of Tax-Loss Harvesting

Tax-loss harvesting is one of the most popular options amongst investors to maximize after-tax returns. But many individuals don’t know this strategy comes with its own risks.

There’s always the lurking risk of selling a stock just about to pick up or is temporarily down due to market speculation. There is also the fact that market analysts believe that the overall effect of selling investments and re-purchasing them again is just a tax deferral and not a gain.

Conventional investors also hold tax-loss harvesting in contempt because it goes against the fundamentals of investing which state to buy low and sell high. Selling important stocks pivotal for diversification to save a few dollars on taxes is a hard note for many investment veterans to swallow.

Below, I summarize the pros and cons of tax-loss harvesting.

Online Robo Advisors that Offer Tax-Loss Harvesting

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.

Related: Top Robo Advisors

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 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.

With all of that being said, several factors go into an effective tax-loss harvesting strategy. These elements include keeping a record of the costs basis of each investment, getting the sale time right and awareness of your tax bracket.

You could manage all the elements, but things get complicated if you have multiple investments.

Most online robo advisors offer tax-loss harvesting as part of their services. Some of the best ones include:

Betterment

Betterment provides investors the perfect strategy by automating asset allocation on the platforms tax coordinated portfolios. The strategy deployed by Betterment can increase tax returns by 15% over thirty years.

The company utilizes tested algorithms on its Tax Loss Harvesting Feature+ feature for daily assessments of tax-loss harvesting opportunities.

Read more: Betterment Review; The Original Robo-Advisor

M1

One of the top online brokerages, M1 has some of the lowest fees in the industry as it charges no management or commission fee. Though the company doesn’t offer tax-loss harvesting, it does offer tax minimization that helps to reduce taxes when selling a security.

Read more: M1 Review; A Free Robo Advisor with a Twist

Wealthfront

The company estimates that its tax-efficient portfolios and bond diversification can net an after-tax return of 0.5% per year. The company offers tax-loss harvesting as a free service to customers using the platform.

Wealthfront assesses tax-loss harvesting opportunities daily. It identifies loss-incurring ETFs and purchases alternative ones as a replacement. You can override the company’s buy and sell decisions if you don’t want to utilize the tax-loss harvesting feature for specific ETFs or stocks.

Read more: Wealthfront Review

Empower Wealth Management

(Personal Capital is now Empower)

Empower Wealth Management is a registered investment advisor (RIA) which means they are bound by the law to act in the best interest of their clients. The firm offers timely rebalancing and tax minimization including tax-loss harvesting features. Read our full review of Empower here.

Related: Empower vs. Betterment Comparison

Bottom Line

Not everyone can invest like Warren Buffett, and the rest of us need a cushion to prevent us from free-falling into an oblivion-like loss. If that cushion is helping us minimize the financial impact of losses through tax savings, then it is better than having no fallback option. However, tax loss harvesting is a reactive strategy, not a proactive one.

DoughRoller receives cash compensation from Wealthfront Advisers LLC (“Wealthfront Advisers”) for each new client that applies for a Wealthfront Automated Investing Account through our links. This creates an incentive that results in a material conflict of interest. DoughRoller is not a Wealthfront Advisers client, and this is a paid endorsement. More information is available via our links to Wealthfront Advisers.

Empower Personal Wealth, LLC (“EPW”) compensates Webpals Systems S. C LTD for new leads. Webpals Systems S. C LTD is not an investment client of Personal Capital Advisors Corporation or Empower Advisory Group, LLC

Additional Resources:

• Evaluating The Tax Deferral And Tax Bracket Arbitrage Benefits Of Tax Loss Harvesting
• Betterment White Paper: Tax Loss Harvesting
• Wealthfront Tax-Loss Harvesting White Paper