Tax Loss Harvesting [Explained]

In this article, we will answer the question What is tax loss harvesting? How do you do it? and When should you do it?

We’ve all been there, we buy some stocks, they go up, we are happy. However, some of the ones we buy go down. What is a way to make this loss less of a loss? One way is to do what’s called Tax Loss Harvesting (TLH).

What is Tax Loss Harvesting?

Tax Loss Harvesting is selling securities as a loss to offset gains. This is useful whether someone is a swing trader or someone who buys and holds. Typically, buy and hold investors tax loss harvest in December because it is the last month of the year.

Now you may be wondering, if I sell a security, wouldn’t my portfolio balance be off? For example, let’s say you normally allocate 10% of your portfolio in 2 different banking stocks Stock A and Stock B with each consisting of 5% of your portfolio. If and you sold all of Stock A, you would no longer be holding it, which would cause your portfolio to be out of balance. To alleviate this imbalance, you can buy Stock C which has a similar profile to Stock A to replace it. 30 days later, you can go ahead and sell Stock C and rebuy Stock A to regain ownership of Stock A.

Tax Loss Harvesting Rules and the Wash Sale Rule

Some people may wonder, why didn’t we just sell Stock A at a loss and then rebuy Stock A? This way we realize the loss but also keep the same portfolio allocation. The IRS already figured this out and implemented what is called the Wash Sale Rule. In simple terms, you cannot just realize a loss to avoid paying taxes without any drawbacks. Let me explain why we need to sell Stock A and then buy Stock C. According to the IRS,

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 account (IRA) or Roth IRA.

If your trades fall under a Wash Sale, you will not get the benefits of tax loss harvesting. Therefore it is important to avoid buying substantially identical stocks or securities within 30 days of selling a stock with losses.

You may be wondering what substantially identical means. In most cases, stocks of different companies are not considered substantially identical, but exceptions occur.

How to Tax Loss Harvest?

Tax Loss Harvesting Example

The way Tax Loss Harvesting works is by selling securities at a loss to reduce realized capital gains or ordinary income. If your investment in Stock ABC appreciated by $8,000, and you realize that gain by selling at a profit of $8,000 in Long Term Capital Gains, you would normally get taxed on that gain. In the same year, if you had Stock XYZ lose $11,000, you are often able to offset the $8,000 gain and have a capital loss of $3,000 if you realize that loss by selling XYZ.

Let’s say it is December 31st and you sell XYZ and ABC to realize both their gains and losses. You then use the proceeds from selling stock XYZ to buy stock 789 which is in the same industry. After 30 days, you would sell stock 789 and rebuy stock XYZ to regain your original positions.

In this scenario, we realized $8,000 in capital gains and $11,000 in losses. The best part about losing this additional $3,000 is that you can often use this to offset ordinary income as well. If you are making $100,000 a year, you will be in the 24% Federal Tax Bracket. You may be able to reduce your ordinary income to $97,000 and thus save $720 in taxes with Tax Loss Harvesting. Note that in this example, we also offset the $8,000 in capital gains from Stock ABC, saving us $1,200, making the total tax savings $1,920.

Note that you only want to do this in NON tax advantaged accounts. Tax advantaged accounts do not typically incur taxes, so it is not needed.

When should you Tax Loss Harvest?

An ideal time to employ a tax loss harvesting strategy is when you are in a high tax bracket and have securities that have lost value throughout the tax year. The security that loss value should also have a similar security available that you can purchase to keep consistency for your investment strategy. Lastly, one will want to ensure that they obey the wash sale rules in order to benefit from tax loss harvesting. Tax loss harvesting can be done at any point in the tax year, but most people do it in December because it is often a time when people rebalance their portfolio, and it is also the end of the tax year.

Should you Tax Loss Harvest?

Many robo advisors that offer automated portfolios always pitch a tax loss harvesting function in their premium plans. While they have studies that show that Tax Loss Harvesting may help in most cases, there are many other studies that contradict this and show that the benefits are often exaggerated. You can always realize the gains and losses in a future year instead. In the long run, you want to maximize the amount of money you have by the time you need it, so everyone’s situation is different.

The drawbacks of tax loss harvesting also cannot be ignored. The fact that you need to buy a security that is not substantially identical causes disruptions in people’s portfolio allocations, and you may experience losses from a suboptimal strategy.

Overall, I personally do a tiny bit of tax loss harvesting, but it is not the main way I grow my portfolio. It is merely a tool that can add a few decimals of percentage points to my net worth.

Will I tax loss harvest in 2020?

I’ve been fortunate enough to not experience many losses, so even after learning about this whole technique, I do not employ it every year. In fact, my portfolio gained approximately 45% in 2020, so I do not have many tax lots that have unrealized losses. As of today, I have 9 tax lots in 5 securities in my portfolio that suffered losses this year of around 3.5%, but combined, the value of these holdings make up less than 1% of my portfolio. Furthermore, one of these companies is an ADR and another is a cybersecurity company that don’t really have a similar companies that I could hold while waiting the 30 day wash sale period.

It is simply not worth doing this whole process for 0.035% of my portfolio value. I typically do not bother with tax loss harvesting if I am only deducting a few hundred dollars as it is not worth the trouble or effort. For example, people in the 24% tax bracket would save $96 after harvesting $400 of losses.

Again, this doesn’t mean tax loss harvesting hasn’t been useful for me in other years, as I have saved a considerable amount in previous years. Your mileage may vary.

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