By Dr. James M. Dahle, Emergency Physician, 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!