Tax Savings Strategies For Your Portfolio: Tax Loss Harvesting

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This article was originally posted on www.michaelsheaplanning.com

Many individual investors get started with investing in the stock market through their retirement accounts. The most common types of accounts being their employer’s 401(k) or 403(b) plans. These plans are great due to easy access to investments, tax deferral and matching components. They are the natural place to start saving and investing.

As you progress in your career or business you may begin to max out your allowable contributions to your retirement accounts. A lot of times a taxable investment account is the logical next step to save money. These are non-retirement accounts with no restrictions on how much you can put in or pullout. You are subject to income taxes and capital gains tax depending on your investments. This is where tax loss harvesting can come into play.

I want to build off my previous post on capital gains tax and expand on the concept of tax loss harvesting. This can be a powerful strategy to help you save money in taxes with your investment portfolio if implemented at opportune times. You can see my previous blog post by clicking here.

Definition of Tax Loss Harvesting

I will reiterate from my previous post the basic concept of harvesting losses and gains. Tax loss harvesting and tax gain harvesting occur when you sell an investment and buy a different one in its place. You are harvesting the losses or gains by intentionally selling the position and buying a different position thereby keeping the money invested. The goal is to take the tax hit now, or capture the loss, allowing you to take advantage of either lower capital gains or income tax rates depending on your situation.

Tax Loss Harvesting Benefits

Capital losses can be used to offset future capital gains or be deducted against ordinary income up to $3,000. Capital losses can carry forward into future years.

If you are deducting losses against ordinary income you can estimate your tax savings by applying the amount deducted towards your marginal income bracket. For example, if you are in the 32% tax bracket you would be saving roughly $960 in taxes. If you deduct long term capital gains against long term capital losses you would be reducing the amount subject to capital gains tax.

If you were subject to the 15% long term capital gains tax and had a $50,000 LTCL (Long term capital loss) to offset a $50,000 LTCG (Long term capital gain) this would result in savings of $7,500.

I have included an example portfolio below to give you a visual representation of tax loss harvesting.

When reviewing your portfolio it is important to be aware of the different items in this chart such as purchase date, cost basis, and current market value. This will provide you with the information you need to make an assessment of which funds to sell and what the tax implications will be.

As you can see, this hypothetical portfolio has two positions with short term capital losses, one position with a long term capital gain, and one position with a long term capital loss.

The above chart simply shows you selling Fund D which was purchased in November of 2015. Any gains or losses associated with this fund would be considered long term and subject to preferential tax treatment because it has been held for longer than one year, since we sold it in July of 2020. Therefore, when we sold out of Fund D we have a long term capital loss of -$14,400.

If we use these tax assumptions this loss can help us do the following:

1. Off-set gains either now or in the future. This applies to both short term and long term gains. For example if we sold $14,400 of Fund C we can estimate the tax savings to be roughly $2,160 (15% x $14,400). If Fund C was held less than a year the tax savings would be roughly $4,608 (32% x $14,400).
2. Deduct up to $3,000 from ordinary income. If this loss is not used in the current tax year then you can deduct up to $3,000 against ordinary income. This results in tax savings of roughly $960 as stated previously in this article.
3. Piggybacking off number 1 you can carry the loss forward indefinitely to future years if you decide not to use it in the current tax year. This can come in handy if you have made a bad investment and want to get rid of it. You can sell it and take the loss. In the future if you have a large gain in the from selling other stock or a business for example the loss can help offset it.

Wash Sale Rule

You need to be mindful of potential wash sales when implementing tax loss harvesting strategies. Be sure you are not selling out of and purchasing the same securities within 30 days of taking a loss. This goes for all of your accounts and your spouse’s accounts as well.

Review any model portfolios if you are making contributions on a regular business to make sure you are not accidentally triggering a wash sale. I have included the definition below.

Wash sale definition:

This is straight from the IRS publication 550:

You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities.

A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

1. Buy substantially identical stock or securities,

2. Acquire substantially identical stock or securities in a fully taxable trade,

3. Acquire a contract or option to buy substantially identical stock or securities, or

4. Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.

If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

Substantially identical securities:

Tax loss harvesting can be put in jeopardy due to the wash sale rule. You need to be mindful when harvesting losses that you cannot buy a substantially identical security or fund. This is defined by the IRS and if it is violated you will be subject to the wash sale rules, where the loss will be disallowed.

Degrees of Risk:

There is not a lot of precedent regarding what is considered a substantially identical security in order to avoid the wash sale rule. It is straightforward in the sense that you cannot buy the exact same individual stock or fund with the same ticker. You can’t sell out of Tesla and buy it back, for instance. That is the same security, obviously.

The interpretation of the definition can get a little more complicated when you are trading mutual funds and exchange traded funds. This is because various fund companies can have similar investment objectives and the nature of these funds creates more grey area. You get into technicalities of how a fund implements trading, taxation, and market exposure.

The main consideration is to be aware of the wash sale rule when implementing these strategies. When considering a replacement fund you can look at the fund family or company, investment objective, active vs. passive, and taxation differences to determine the degree of risk should you be audited by the IRS.

Cost basis methods:

When considering making changes to your portfolio you need to understand your cost basis method when buying and selling securities. The most common methods are last in first out, first in first out, and high cost. These terms act similarly to how they sound. You can select your preferred cost basis method if you are using rebalancing or trading software. The software will then automatically propose trades based on your tax lot settings.

The custodian and fund companies keep track of your individual trade lots, or purchases, over time. If you are contributing money on a monthly basis you typically are buying into the same funds over time. This is where your cost basis method can become more important.

FIFO – First in first out or FIFO means that the first trade lots purchased will be sold. Under this scenario you are looking to sell your oldest shares. These are the shares you have held the longest. This means long term capital gains will be on your side due to the holding period most likely being longer.

LIFO – Last in first out of LIFO is when you are selling the trade lots that were bought most recently. This can be useful if you have shares that were purchased a long time ago and have appreciated significantly, as they could have been purchased at a lower price.

Highest Cost – The high cost method is when you are selling shares that have the highest price. This can help keep your capital gains lower since these will likely have appreciated less than shares held longer.

Lowest Cost – The low cost method if the opposite of the high cost method. The shares that were purchased at the lowest price will be sold. This means that the gains will be higher than shares purchased at a higher price.

Specific lot – You can also manually pick and choose which lots you would like to sell. There can be many variables to take into consideration so you may want to choose certain lots or investments depending on your situation.

Tax Loss Harvesting Strategies

Tax loss harvesting can be implemented in a down market or if an investment has not done well and you want to get rid of it. The benefit of tax loss harvesting is that the losses can offset income or capital gains, either now or in the future.

If you have a capital loss for the year this can be deducted from your income for up to $3,000. A capital loss can be carried forward to future years where it can be deducted against income or offset future gains.

If there is a down market you can take the loss and buy a different security to where you still are invested but you have the losses in your pocket for future use. That is the concept or advantage of reviewing your portfolio during volatile markets or selling out of poor performing stocks.

Is Tax Loss Harvesting Worth It?

I would recommend reviewing your portfolio throughout the year to see if you can strategically rebalance or harvest losses or gains depending on your situation and what the market is doing. Some people only harvest losses at year end but I would encourage this to be done periodically such as monthly or quarterly. You can also set up certain parameters to alert if you have an investment that has decreased or increased by a certain percentage. This could help you with monitoring your portfolio and implementing changes as needed. Research has shown that tax loss harvesting can be beneficial over time. Obviously, this is largely dependent on your individual situation.

There are many software options that DIY individual investors can use to monitor and implement tax loss harvesting such as Betterment and Wealthfront. These are two of the more popular robo-advisors that have established themselves in recent years. We use TD-Ameritrade Institutional and their rebalancing software to manage client portfolios on their behalf. Software can assist you in rebalancing your portfolio and in helping you understand the tax implications of selling your investments. As always, feel free to reach out with any questions about your situation. I offer a no-cost portfolio review and consultations.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER? at Applied Capital. Email him at [email protected] or fill out a contact form.

DISCLAIMER

This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.