This has been a rough year for investors. The stock market averages have been down double digits for most of the year. We are clearly in a bear market for equities.
To make matters worse, bonds have also dropped significantly this year, meaning the lower risk 60/40 type portfolios are down almost as much as the all equity portfolios.
Inflation has been elevated all year and interest rates are up significantly.
There is probably a recession on the horizon, if it is not already here.
We are all in need of a silver lining and I have good news to share today. For the next few weeks you have a rare opportunity to lock in some large tax savings now and for the future of your investment portfolio.
The strategy is called tax loss harvesting.
First of all an important disclaimer. I am not a CPA or tax advisor. I am only a retired financial planner. These strategies have been implemented for my own portfolio and for countless clients over the years in coordination with a good CPA. Please use this information as a starting point. Before you make any changes consult with a real CPA or Enrolled Agent.
Income Vs. Capital Gains
The IRS has different rules and tax rates for different types of income. As it relates to your investment portfolio there are basically two different ways to trigger a tax. One is when your portfolio generates income either in the form of interest of dividends. The other is when you sell a position for a higher price than you bought it for. This is called a capital gain.
Most types of portfolio income are taxed at the same rate as the rest of your income, such as that from your employment (ordinary income). This includes interest from taxable bonds, CD’s, and money markets. This also includes several types of dividends such as from preferred stock, real estate (although there may be other special tax treatment here that is beyond the scope of this article), and some private and public equities.
Dividends from most common stocks are taxed at a lower rate.
For capital gains, the IRS differentiates between short term and long term. Assets held less than one year before being sold for a gain are taxed at ordinary income rates. However, for assets held longer than one year there is a special, lower, capital gains rate. Depending on your overall income this rate can be as low as 0% and as high as 20%. This compares to the top ordinary income tax bracket of 37%, or almost half!
| Taxable Income | Tax Rate |
| $0 – $83,350 | 0% |
| $83,351 – $517,200 | 15% |
| $517,200+ | 20% |
Harvesting Capital Losses
Sometimes (such as in our current bear market) instead of a capital gain in your portfolio you have an unrealized capital loss. If you sell this security and realize the loss, instead of paying tax at the capital gains tax rate you would generate an equivalent tax loss.
For example, let’s say that you bought 300 shares of Tesla earlier this year for $300/share, or a total investment of $30,000. You have since soured on the company and decided to sell all of your shares when they are trading at $180. You now have a loss of $120/share or $12,000. This loss can now be used as an offset against other income, with some caveats I will list below.
The Rules Of Tax Loss Harvesting
- You cannot re-purchase the same or “substantially identical” security within 30 days before or after the sale. So, no selling Tesla for the loss and then buying it back the same day. This is called a “wash sale”.
- You can offset an unlimited amount of capital gains in a given year.
- If you run out of capital gains to offset you can use your loss against up to $3,000 of ordinary income in a given year.
- Any unused losses (assuming you have less gains than losses that year, which you probably do in a bear market!) can be carried over indefinitely to be used in future years to offset future gains.
The Tax Loss Harvesting Strategy
For most investors harvesting their tax losses the goal is to realize the benefits of the tax loss during this temporary downturn in the market. However, you likely want to also stay invested in your current asset allocation and get the upside when the bear turns into a bull.
Step one is to identify your current unrealized losses. Most brokers will have a page on their website where you can see this, and most statements will show at least the cost basis next to the market value.
Step two is to select the securities you would like to sell. This year that may be both stocks and bonds. The more tax losses you can generate the more you will be able to offset future gains.
Step three is the harder part. What to do with all of the cash you just generated from the sales? One option is to wait 30 days and repurchase the same security. The risk here is the opportunity cost of being out of the stock for a month. There tend to be occasional large rallies during bear markets and the stock may go up, causing you to have to buy it back at a higher price!
A second option is to purchase a similar, but not substantially identical security. For example, you sell Ford, and then purchase GM. You could then hold GM, or sell it 30 days later to repurchase Ford. In this case, you are hoping that GM will perform similarly to Ford during the hold period.
A third option is to purchase an ETF or mutual fund that tracks the industry. For example an ETF that holds a basket of automakers. This would be similar to option two with the benefit of some diversification.
Unfortunately, when it comes to ETF’s and mutual funds, the IRS has not been very clear on what qualifies as substantially identical. Caution is warranted here. For example, trading a Vanguard index fund that tracks the S&P 500 for a Fidelity index fund that tracks the S&P 500 would probably qualify as substantially identical. Purchasing a fund that tracks another large cap US index, or an actively managed large cap US fund might be OK. This is where it is important to work with a good tax advisor!
Don’t Forget About Your Bond Funds
Most years, tax loss harvesting is an exercise in identifying under-performing equities. However, due to bond market losses in this new economic era, it is likely many of your individual bonds or bond mutual funds have an unrealized capital loss. This could be a good time to sell one bond mutual fund and reinvest in another similar (but not substantially identical) fund.
Other Tax Loss Harvesting Considerations
- It is important to note that harvesting these losses and repurchasing the security doesn’t make the tax go away completely. It simply allows you to realize the loss now (when it may be more valuable to you) and defer the gains to the future. Tax deferral is a great wealth building benefit, but it is important not to overstate it.
- In the years when you have a tax savings, make sure to reinvest those savings into your portfolio! This will help with the magic of compounding.
- If you think you will be in a significantly higher capital gains tax bracket in the future this strategy doesn’t make as much sense. This is especially the case if you are in the 0% capital gains bracket. In that case, you may consider harvesting gains instead!
Tax loss harvesting is a smart exercise to put on your portfolio management calendar each year. In a bear market year like this one you may be able to lock in substantial losses. As your portfolio inevitably returns to growth your future self will be thanking you as you offset future gains with the losses you realized now.
Further Reading:
IRS Topic 409 Capital Gains and Losses (IRS)
IRS Pub 550 Wash Sale Rule Definition (IRS)
Wash Sale Challenge: What is substantially Identical? (Morningstar)
