By Dr. James M. Dahle, WCI Founder
Every now and then I hear somebody poo-poo the idea of tax-loss harvesting. They say it isn't worth the effort and additional complexity required to do it. Well, they're wrong. Especially in my case, but actually in the case of most people. Let me explain.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the idea of selling a security (usually a mutual fund) with a loss in a taxable account (you don't do this in your 401(k) or Roth IRA) and then immediately buying a similar investment (i.e. another mutual fund that has very high correlation with the original mutual fund) that is not, in the words of the IRS, “substantially identical”. For practical purposes, substantially identical simply means it has a different CUSIP number than the original mutual fund. Your asset allocation has not changed, but you have “booked” a loss that you can use to offset any capital gains you are forced to realize. If you have some extra losses, you can use up to $3,000 per year to offset your ordinary income, and then carry anything left over to the next year indefinitely. You could have thousands or even millions of dollars of losses carried over year to year.
Substantially Identical Rule
There are a few rules. I mentioned the substantially identical rule. That means you could swap a Vanguard Total Stock Market Fund for a 500 Index Fund, but you couldn't swap a Vanguard Total Stock Market Fund for a Vanguard Total Stock Market ETF. Those are substantially identical. Now, some people think the IRS really dives into the details of these transactions, but I don't know anybody who knows anybody who has ever been audited on this point. They have bigger fish to fry. So I really wouldn't spend any time worrying about it. Certainly in this case one fund holds thousands more stocks than the other, so it is an easy argument to make that they are not identical. You can also argue that two indices and the holdings themselves are different even if you're using a Total Stock Market fund from two different companies.
Wash Sale Rule
The easiest rule to screw up is the wash sale rule. That means you can't turn around and buy the same security in the 30 days after you sell it or the basis is reset and that loss you were trying to get is washed away. You also can't buy it in the 30 days BEFORE you sell, UNLESS you also sell the shares you just bought.
You also can't buy the same security in an IRA that you just sold in taxable. The tax code doesn't say you can't buy it in a 401(k), but I think that is at least against the spirit of the rules.
Be careful buying and selling frequently, of course. If you don't hold a security for at least 60 days around the dividend date you will turn that dividend from a qualified dividend into a non-qualified dividend, eliminating a lot of the benefit of that tax loss.
So Why Do Some People Think Tax-Loss Harvesting Is a Bad Idea?
Seems great, right? So why do some people argue it's a bad idea? The crux of their argument is that when you tax-loss harvest, you are resetting the basis on that security to a new, lower value. So when you sell it, more of its value will be taxable as a capital gain. So in reality, you are just deferring those capital gains taxes. It's a crummy argument for many reasons, but let's listen to someone make it. In this case, Steven at Evanson Asset Management. He says:
“On the surface tax-loss harvesting makes sense. Seldom mentioned though is that tax-loss harvesting can only be certain to add value when the harvested proceeds from the loss are never again reinvested in the asset class from which the harvest was taken or the owner is deceased and the cost basis has been reset at death. This isn't usually the way it's done because most investors will reinvest the proceeds in the same asset class and fund, usually after 31 days. This replacement will then presumably start at a lower cost basis after harvesting and thus more taxes will be due on it in the future if it is ever sold. If the price of the harvested asset has climbed before it is repurchased then the gain in value before repurchase will reduce the potential profit….If capital gains tax rates have increased, and they are low historically as of 2019, an investor may end up paying more in taxes then if they had not initially done tax-loss harvesting….Many investors will probably sell most if not all of their equities in taxable accounts before they die.”
That's it. That's the whole argument. Let's poke some holes in it.
#1 Tax Deferral Has Value
The idea that the ability to defer taxes has no value is silly. Would you rather have money now or money later? Now, of course. That's why there are time value of money calculations. If you use a 4% rate, $1,000 now is worth $3,243 in 30 years.
#2 Only Idiots Realize a Gain to Go Back to the Original Investment
The idea when you swap investments is that you are also perfectly happy to hold the replacement investment forever. I mean, they're practically the same, just not substantially identical. If there has been no appreciation in the previous 31 days and you slightly prefer the first investment, sure, go back. Or better yet if the new investment has also lost money, then tax-loss harvest again back into the original investment. But otherwise, just keep the one you swapped into. What's the big deal? If you're using the broadly diversified index funds I recommend to you for your taxable account, there are usually a half dozen choices in every asset class that are perfectly fine.
#3 Swapping Ordinary Income Tax Rates for Long Term Capital Gain Rates Is Smart
When you tax-loss harvest, at least the first $3,000 per year (above and beyond any capital gains you have), you get to put that against your ordinary income. But when you eventually sell that investment (so long as you have held it at least one year), you don't pay ordinary income tax rates on the gains. You pay at the lower LTCG rates. That's a win.
#4 LTCG Tax Rates Could Go Down Too
Steven warns that LTCG tax rates could go up in between the time you tax-loss harvest and the time you sell the security. Sure. But they could also go down. People are always warning about tax rates going up, saying “They have to go up!” Well, until something like the Bush or Trump tax cuts come along. And they fall. Even if the tax rates themselves don't move, chances are you are in a 15-20% LTCG tax bracket right now. It is entirely possible that you will be in the 0% LTCG bracket in retirement when you sell that investment. That's another win.
#5 You Are Unlikely to Sell All Your Shares
This is the big one. Even if those four advantages listed above didn't exist, this one would be enough to justify tax-loss harvesting. Almost nobody is ever going to sell all of their shares. In retirement, if they have to sell any, they'll sell the ones with the highest basis first, not the ones they tax-loss harvested in that big, bad, bear market 30 years prior. They'll leave at least some, if not the majority of their shares, especially their low basis shares, to their heirs or their favorite charity, neither of which will owe taxes on the gains when they sell the security due to the step-up in basis at death. (Not that charities pay taxes anyway on capital gains.)
If you are a charitable person, you can implement an even more powerful technique that Katie and I use. We donate lots of money to charity every year, lately through our Donor Advised Fund at Vanguard Charitable for convenience and anonymity. But instead of donating cash, we donate appreciated shares. Which ones do we donate? The ones with the lowest basis, of course, i.e. the ones we tax-loss harvested in the big, bad, bear market. So long as we have held them at least one year, we get to use the full value of the charitable donation as an itemized deduction, the charity gets the full value to use for its purposes, and neither we nor the charity pay any taxes on it. Those gains are simply flushed out of our portfolio. And we can repurchase the exact same shares we donated back the very next day, even the same day, as there is no 30-day waiting period like with tax-loss harvesting. We basically never pay capital gains taxes. With the tax-loss harvesting, our tax bill from capital gains is actually negative!
# 6 Tax-Loss Harvesting Allows You to Fix a Bad Portfolio
Many of us bought some investments in our taxable account before we really knew what we were doing. Now we're stuck with them because we don't want to pay the capital gains taxes we would owe if we sold them. However, if they fall in value below basis, we can sell them and buy the investments we should have bought in the first place. Even if those “crummy” investments are still above basis, we can sell other shares at a loss and use those losses to offset the gains that would come from selling the crummy ones. New improved portfolio at no tax cost.
# 7 You May Find a Really Good Use for Those Losses Someday
We have now booked enough losses that we could take $3,000 of them each year for the next two or three lifetimes. But we're still tax-loss harvesting. How come? Well, there's the possibility of selling The White Coat Investor someday down the road. If we do, we'll owe LTCG taxes on the entire value. Wouldn't it be nice to have a few hundred thousand or even millions of dollars of losses to offset that gain? It sure would. Maybe you'll be in a similar situation someday. Worst case scenario, you sell those shares and pay the capital gains taxes on them later. No big deal.
# 8 It's Just Not That Hard (or Complex)
The only remaining argument against tax-loss harvesting is that it is a hassle and adds some complexity to the portfolio. I find that one pretty weak. It's not like you have to do this every month. You only really need to do it when the market goes stark raving mad. So maybe you do it in 2008, in 2011, in 2018, and in 2020. Four transactions in 13 years. And so you have a couple of additional mutual funds or ETFs in your taxable account. I think I can deal with that kind of hassle for thousands or even hundreds of thousands off my lifetime tax bill.
As you can see, tax-loss harvesting is useful for most people. For some people (the charitable kind and those who will leave most assets to heirs) it is VERY useful. Before listening to those who poo-poo it, look at your own situation and calculate what it would be worth to you and make your own decision.
What do you think? Do you tax-loss harvest? Why or why not? Comment below!
Maybe I missed it but it didn’t seem that he addressed having to live with a new lower basis once you buy back into the shares. Purchased at $100, after two years the share price went down to $70. I sell to capture the loss. When I want to buy again after 30 days my new basis is $72. When I go to sell in 5 years my capital gains are larger then if I had just held onto to the original shares.
That’s correct. But you still get the time value of money on that cash in between TLHing and your eventual sale. Plus you might never sell it. Plus, for $3K a year, you’re saving at ordinary income tax rates but later paying at LTCG rates.
Big fan of tax loss harvesting.
I don’t mind lowering my basis when harvesting losses because I will, with near certainty, be in a lower tax bracket when I stop working compared to now. And if you keep your annual expenses relatively low (for a doctor), the long term capital gains rate is zero.
I kept saying on Bogleheads before I gave up, that if you aren’t TLH, you are not doing it right. It’s a free $3000 deduction every year PLUS you can use the losses against future realized gains. It’s a great deal. If you purchase film tax credit (in certain states this is a common strategy for high-income earners) the benefit is quite palpable every year. The argument I run into frequently is that it’s too much trouble. I can sell and buy on my smartphone in literally seconds. Fidelity keeps track of it for me. How much trouble is that? One problem I have run into is harvesting a bit too early (predicting the future is hard right?) and I ran out of emerging market funds to use. Fidelity only has one low-cost EM fund. I ended up buying a total international that had the most EM. Not quite the EM tilt I preferred, but that is a pretty small problem in the big picture of tax savings.
Thank you, Dr. Dahle. I was thinking about TLH last week and then you posted this timely blog post. I am considering moving my taxable account only to one of the brokerages with automatic TLH, typically a feature of a robo-advisor option. WealthFront, SoFi, Betterment, and some others have automatic TLH.
If we make the argument (which is a personal decision just like portfolio design, e.g. some folks do better pumping money into a very simple portfolio) that managing and dealing with TLH is not going to happen unless it’s automated, do you think the low fee structure of a robo advisor that includes automatic TLH negatively outweighs the benefit of TLH. WealthFront has very favorable feedback all around. Seems like a reasonable way to start TLH versus doing it yourself or asking your financial advisor or accountant to take it on.
Would you love your insights on this. Thanks!
I have a hard time buying the argument that it is worth hiring a roboadvisor JUST for the tax loss harvesting feature. After $3K a year, the benefit rapidly diminishes for most. And once you have a decent size portfolio that goes through a bear market, you’ve got $3K a year for a long time. For example, I’m sitting on something like half a million in losses right now. That’s like 150 years of $3K a year deductions.
Perhaps a silly question, but what is the mechanism for carrying losses forward until they are needed? This year we had more than $3000 in losses that were harvested and we used $3000 to offset income. How do we keep tabs on this for future use to keep the IRS happy?
It’s carried forward each year on worksheets associated with Schedule D.
I don’t know how many people say never to TLH. Rather, many point out that, as Jim just noted, the value erodes quickly.
The robos that offer this, I gather, extract every loss, no matter how small. One commenter on the WCI forum reported getting an 89 page 1099 one year. Many of the transactions were for less than a dollar of total loss. At that extreme transaction costs could swamp any tax benefit. Plus the time required to check for wash sales and prepare the tax return.
I do some TLH, but I have the problem that my investments are on autopilot and have been for years. I make automatic purchases every pay period. If I wanted to TLH in these funds, I would have to switch to all manual purchases, which is too much hassle. We have some individual stocks, obtained long ago and we TLH them when the opportunity arises. But because we have flushed out the losses, almost everything left is very low basis and it is unlikely the value will ever get that low again. Possible but it would require something worse than the Depression to get there.
Those are assets we plan to keep for life and pass on to our heirs. Under current law the basis will step up.
I’m amazed how this technique is sort of a secret among high income charitable people. This is an awesome way the government supplements my giving indirectly. Shares I harvested last March now are great targets for giving. I struggle with the DAF. I have looked hard at Vanguards. I did 5 gifts myself on the Vanguard website outside a DAF last month actually through my phone. It takes me 30 seconds each. I’m tempted to switch to the DAF but can’t justify the fees. They were higher than I expected. Outside anonymity, which I get, are there advantages I miss? It is annoying I can’t give a specific dollar amount in the app but only a number of shares so the amount fluctuates based on when it clears. Is that the same with DAF? Other advantages of the DAF? Thanks
The fees can be minimized by not leaving any money in the DAF aside from the required $25K every February/March.
POF justifies them by pointing out the tax drag in a taxable account is about the same. So if the asset is going to charity eventually, it doesn’t matter if it sits in your taxable or the DAF.
The nice thing about the DAF is you can just put the money in cash and then specify a dollar amount.
Interesting. One follow up. I see the anonymity as a value. However with the biggest charity we donate to I get a 65% state tax credit through the donation. Are you able to make the donation not anonymous if you choose so I can still get the state tax benefit in addition to federal? Thanks
No. Your donation is to the DAF. So you wouldn’t get that special tax credit. You’d need to give directly to get that.
You can make the donation not anonymous, but I don’t think that solves your issue. Maybe ask your charity.
Another advantage of DAF is that some charities are not set up to receive stick donations. Or it is a hassle collecting the information, walking them through it and arranging the transfer. With the DAF the charity simply gets a check.
With the DAF, tax reporting is simple. All you report is the donation to the fund. No need to track how much, of what, at which date at which share price was sent to each charity. It can be as simple as one gift to the fund for the year. If you bunch your gifts to get above the standard deduction, it might be one gift every few years.
We used to have to report the details of dozens of gifts each year. Since we have had a DAF it is much easier.
Schwab and Fidelity have DAFs with lower minimums. I think the expense ratios are about the same but you may want to check.
Clearing out the fund after donating is the strategy to minimize the amount of money paid in expenses.
The other thing that is nice about DAF is timing. You can choose when to give to the DAF, but decide when to recommend the grants to the end charity.
Now that the standard deduction is so high, one popular strategy is to itemize deductions in a given year where it makes sense to overfund the DAF and then pull the charitable giving out in successive years. I did this just prior to the Trump tax rules went in. Also, prior to retirement, I plan to do this and fund my DAF to at least 30% of my AGI (the max for stocks) and use that lump sum for many year when I’m in lower tax brackets.
I have a lot of my taxable investments with Personal Capital and they promote the fact they do tax loss harvesting. However they do not itemize the amount of savings that results in. I wish they did since it is hard to value something you can not measure. It is one of the reason I accept the relatively high (0.79%) fee they charge me to manage my investments. But I have no idea how much of that I get back from the TLH.
Depends on how much you have invested. If you have $5 Million with them I guarantee you aren’t getting much of that $40K back from tax loss harvesting.
“you can’t turn around and buy the same security in the 30 days after you sell it or the basis is reset and that loss you were trying to get is washed away. You also can’t buy it in the 30 days BEFORE you sell, UNLESS you also sell the shares you just bought.”
This was so clear and concise – excellent wording. If livesoft wrote that well, he’d have 50k fewer posts, lol.
Yea, that last phrase is really important and it takes people a long time to “get” that.
Is that “unless you also sell the shares you just bought” part definitely correct? I can’t seem to find any information about that anywhere online except on this page. Are there any posts/sites/pages that go into more detail on that? In particular, I’m wondering if Fidelity (which flags and adjusts automatically to reflect the wash sale rule for you) will handle it appropriately. Also wondering if it has to be sold at the exact same time or how that works.
Yes. Tried and tested by me. But you’re right, there isn’t anywhere that really talks about it. But if you think about it logically, it makes sense. Imagine you bought 10 shares of something and it went down in value the next week. And you sell them. You never buy shares again and have never bought them before. Of course you should be able to deduct that loss, right? That’s what I’m talking about. That’s not a wash sale.
Alright, I did it and it looks like everything worked great. Thanks as always for the excellent advice!
For anyone stumbles on this thread in the future, I did it through Fidelity, sold specific shares, and just checked the box next to all my purchases from the last 30 days plus any purchases prior to that that were in the negative so that they were all being sold together. Within a minute or so, I was able to buy another similar (but not substantially identical!) security. No flags from Fidelity, which I guess makes sense because I don’t even own the securities they would have flagged anymore. Thanks again!
Any good lists of tax loss harvesting partner funds/ETFs? When searching for this I have mostly just found people arguing about what “substantially identical” means. I mostly just want to find a good list of ETFs for VTI and VXUS to be prepared for the next market drop.
VTI- 500 index, large cap index, growth index funds at Vanguard. You can also look at Fidelity TSM, Fidelity 500, iShares TSM, Schwab TSM, Schwab 500 etc.
VXUS- Similar story. Vanguard has another total international fund, the developed market funds. Fidelity, Schwab, iShares TISM.
Hey Sarah, here is a link to a doc who actually had guest posted here on WCI and now has her own finance blog:
https://physicianfinancebasics.com/tax-loss-harvesting-partners/
I’m paying 1% to a fiduciary advisor on just over $1MM in investments and expect that to grow soon. (I just can’t find the time to figure it all out and do it myself yet, but hope to at some point.) They just introduced TLH for I think 10 basis points (which I understand to be another 0.1%) I give over $100K to charity per year. Is it worth it for me? Thanks, so much, for any help!
They’re going to charge you MORE than 0.1% to tax loss harvest? You need a new advisor:
https://www.whitecoatinvestor.com/financial-advisors/
Hi Dr. Dahle. Thank you for a great post. I had not heard of TLH until I started listening to your podcast. Your description makes intuitive sense and I am planning to incorporate TLH into my overall investment strategy.
I am wondering if there is a minimum time you need to hold the similar investment you have swapped into. For example, say I own a large cap index fund, which I sell at a loss and TLH into an S&P 500 fund. Now I want to liquidate or donate the S&P500 index shares. Is there a minimum time I need to hold the new index fund before selling it? Thank you again!
No. You just can’t go back to the first investment for 30 days or you get a wash sale.
Curious how you can make this work if you are set up to buy regularly. I have auto invest set up for weekly purchases. Seems like it would be hard to find a fund I hadn’t bought into in the past 30 days. Especially one that had gone down a lot since my portfolio would automatically be buying into something that went down to bring back to target allocation.
Auto investing and tax loss harvesting do not play well together.
Thanks Jim for this explanation! After maxing out our tax protected accounts, we finally have a little extra cashflow! We’re thinking of putting it into a taxable account (only other attractive option would be paying down 2.75% mortgage early). As we’ve never before had enough to really buy into taxable, we haven’t had a capital gains loss in 10+ years.
The initial plan was to buy broadly into a tax-friendly total stock market index. But after reading this, I was thinking of purposely investing in a high-volatility less-tax-friendly class (like global REIT, or a sector ETF) to increase the likelihood of either above-market gains, or a loss. I can already feel myself rooting for a loss so we can offset income on our taxes (Admittedly idiotic: losses=bad; gains=good).
From 6,000-feet up–does this plan hold water?
No. I did it once. It was a dumb thing to do. Just invest in what you would regularly invest in. There will eventually be more losses than you know what to do with tax wise. Remember, you can only really use $3K a year. Once you have say a million in there, if it drops 10%, that’s 30 years worth of losses you can use (assuming you’re not picking up gains somewhere.) You don’t need to invest in dumb stuff to get tax losses. You just need to be a little patient.
So I’m confused, if you sell the white coat investor. How would you get to use more than the 3k per year to offset the selling of the white coat? My understanding is it would be 3k per year so if you sell in thirty years it be 90k to offset? What am I not understanding? Thanks for the post!
$3K per year against ordinary income. An unlimited amount against capital gains. The sale of a business, rental property, or mutual fund shares generates capital gains.