Ready For Retirement

Tax-Loss Harvesting Strategies to Maximize Your Benefit and Avoid Costly Mistakes

November 21, 2023 James Conole, CFP® Episode 190
Ready For Retirement
Tax-Loss Harvesting Strategies to Maximize Your Benefit and Avoid Costly Mistakes
Show Notes Transcript Chapter Markers

 Tax loss harvesting is a strategy that investors use to reduce their tax bill. However, there are many misconceptions about tax loss harvesting, including when it's valuable and how to do it effectively.

James debunks some of the most common myths about tax loss harvesting and explains how to use this strategy to your advantage.

Questions Answered:
How can investors benefit from tax loss harvesting by offsetting capital gains and ordinary income taxes?
What are the rules and limitations surrounding tax loss harvesting, including the wash sale rule?

Timestamps:
0:00 Intro
3:59 Listener example
6:26 Identify a replacement security
11:17 Example
17:20 Capital losses
20:30 Looking at tax loss harvest
23:44 Intentionally realizing gains
24:25 Outro

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Speaker 1:

Tax loss harvesting is a strategy that investors use to reduce their tax bill by selling investments that have lost value and offsetting those losses with gains from other investments. However, there are many misconceptions about tax loss harvesting, including when it's valuable and how to do it effectively. In today's episode of Ready for Retirement, we'll debunk some of the most common myths about tax loss harvesting and help you understand how to use this strategy to your advantage. This is another episode of Ready for Retirement. I'm your host, james Kanol, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's episode comes from a listener question. This listener's name is Tim, and Tim wrote in this. He says let's look at a hypothetical John Doe is filing his taxes married filing jointly with his wife and then make $200,000 per year. John sells his shares of his ABC stock that he held over a year and makes a $500 profit in doing so. He owes $75 in long-term capital gains tax on that sale because he's in the 15% federal long-term capital gain tax bracket. Let's assume he then sells a share of XYZ stock that he also held over a year and he loses $100 on that sale. He can now subtract the $100 long-term loss from his $500 long-term profit and he now has a net gain of $400, which now means he owes $60 in taxes In the end. Where long-term gains are concerned, he lost $100 in his tax-house harvesting effort to reduce his taxes by $15, which is the difference between $75 paid in taxes versus paying only $60. Unless you have reasonable certainty that the new investment vehicle you reinvest the money from the sale of XYZ will yield at least $85, so the $100 you've lost minus the $15 tax benefit, you've still lost money. I've never heard any presenter state explicitly that tax-house harvesting still results in net loss. They mostly go up in a tangent about wash-sale rules. A concrete example, as above, of course corrected for any errors or misunderstandings I have about the topic, followed by discussion of what circumstances in which an investor may reasonably expect to come out ahead employing the strategy of loss would be greatly valued. Thank you, tim. All right, tim. Well, thank you very much for that question. In a sense you know what Tim is asking and I think it's a good question. He's saying look, tax-house harvesting has tax benefits. I don't deny that. But those tax benefits maybe are very little or they pale in comparison to the actual losses that you're suffering by selling a stock at a loss. What am I missing here? What gives? Why? Would this actually be a good strategy, assuming that the losses you're realizing from selling a stock offset any of the gains that you're realizing in tax benefits because of that capital loss? Tim, good question, and we're going to cover that on today's episode. Before I do, I want to quickly highlight the review of the week. This comes from a user named MFK1970. They leave a five-star review and they save an outstanding podcast. Thank you for explaining complex concepts in plain language. It enables me to better make decisions and determine what other questions I need to ask. You focus on the most critical issues and provide great examples. You have brought comfort and confidence to my financial planning. Thank you Well, mfk1970, thank you very much for that review. Thank you to all of you who are leaving reviews. If you haven't already done so. It always means a lot to me when I see those come through. If you don't mind taking a couple of minutes, leaving a five-star review, if you found any value from this podcast, sharing this podcast with friends, family, coworkers, people who are looking for good retirement information, would really appreciate you doing so. Hopefully they would appreciate you doing so as well. Let's now get on with the topic. Tim, I'll start by saying this I agree with you A lot of times tax loss harvesting is poorly explained and because of that it's often misunderstood. So let's walk through a clear example of why it works. And to start, let's look at where Tim is right. And just to quickly summarize Tim's point, he provided an example. He said let's assume I sell a stock with a $500 gain. I have to pay taxes on that $500 gain. Let's also assume I sell another stock with a $100 loss. Well, I lose $100. If I sell a stock, that loss is locked in when I sell In. The potential tax benefits for doing so is it offsets $100 of the gains I otherwise realized. But that only saves me about $15 in taxes, or exactly $15 in taxes, if I'm in the 15% federal capital gain bracket. So what I can't understand and I'm talking as Tim here what I can't understand is how would anyone think that's a good trade-off, a guaranteed $100 loss, for only a $15 tax benefit? Well, here's where I would continue this, or here's what I would say you might be missing, tim, is if you just sell the investment and you don't do anything with it, then you're exactly right. You're missing the point of tax loss harvesting. So you sell your investment, your stock, your mutual fund, whatever it is, for $100 loss. That's real money. That's a real loss. If you invested $1,000, it's not worth $900 and you sell it, you lost $100. There's no denying that there's a tax benefit of $15 because that loss offset gains from other stock sells, but the loss still outweighs the gains. Here's what you're missing, though, tim, is ideally or not ideally if you're going to be employing the strategy, you are simultaneously repurchasing a similar investment. That can't be identical. And so, tim, to your point. As people start going off on tangents about wash sales, what a wash sale is is if you sell a stock at a loss. Let's say you own McDonald's stock and you sell McDonald's at a loss and you immediately repurchase McDonald's stock. Well, that's a wash sale. You can't just lock in that loss that you can use on your tax return and then rebuy the same exact investment immediately. That triggers a wash sale. You have to wait 30 plus days to repurchase the same investment, and that's 30 days either prior to sale or post sale, in order to not have any wash sale complications. So, tim, let's look at what you should be doing instead of that. Now, none of this is a recommendation. I'm going to use some specific funds and even some specific ticker symbols in some of these examples. I want to be very clear that none of this should constitute a recommendation or an endorsement of any type. We're just using specific examples to try to make this as practical as possible. So the first thing that you're going to do when you implement tax loss harvesting is you need to identify a replacement security. So don't just sell something because it's down in value and you have some tax benefits to do so. You need to know where am I going to then reallocate those funds? Because if you don't reallocate those funds and you sell a stock or a fund that has a loss, that's just a loss and there's no benefit to the strategy for you. But if, before you sell, you identify a replacement, then ideally what you're doing is you're continuing to maintain your overall exposure to whatever investment you are allocated to, while still harvesting or taking advantage of those losses that you can use to write off against other types of income on your tax return. So, for example, maybe you sell an S&P 500 index if it's gone down in value. Well, if you do that, whatever the loss is, that loss is then locked in. You can use that to write off against other capital gains. You can even use that to write off against some of your ordinary income more on that later, but that loss is locked in Now. What you don't want to do is just keep that money in cash, because now it's not going to go up when the investment that you wanted it to be invested in goes up. So you can't buy an identical security Now. You can't go sell the Vanguard S&P 500 index just to go buy the Fidelity S&P 500 index, for example. That's going to be substantially identical security. But maybe what you do is you sell an S&P 500 index fund, for example, and you buy a Russell 1000 index fund. Now those are very different indices but they have a lot of overlap. The Russell 1000 index is a market cap weighted index that owns the thousand largest companies in the United States. When I say market cap weighted, what I mean by that is it's not as if the Russell 1000 or the Russell benchmark or the Russell index looks at the thousand largest companies and said, okay, each of you get the same allotment of money in this fund. So 0.1% to each stock in the Russell 1000. Instead, the Russell 1000 is saying it's market cap weighted. So Apple is the largest company. Apple is going to have the largest allocation of a Russell 1000 index. Microsoft's a large company. They're going to get a larger allocation. Google's a larger company. They're going to get a larger allocation. So, whatever the percentage of a specific stock in the index, that's how much of an allocation it's going to get. What does that matter? Well, if you look at the S&P 500, it's also market cap weighted. It's also going to own Apple, microsoft, google, these larger companies. So when you're doing this, it's not the identical security that you're purchasing, but the top holdings. The correlation, the overlap is going to be pretty similar there. So, generally speaking and this isn't going to be true 100% of the time, nor to 100% correlation, or perfect correlation at least but if the S&P 500 is going up in general, it's very likely the Russell 1000 index will be going up. So what you want to do is get something similar in place of the investment that you sold and again, you want something that has high correlation and high overlap. But it's not the exact same thing. So if you have questions about, well, what securities could be replacement security without violating the wash sale rule, talk to your CPA, talk to your financial advisor. But this is something that's an important component really a crucial component of the Taxless Harvesting Strategy. Hey everyone, it's me again for the Disclaimer. Please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. I'll walk you through a process we go through internally. So, if we're going to do Taxless Harvesting for clients and, by the way, since the beginning of 2022, a lot of investments have gone out of value. Now, these are never fun times. It's never something that you hope for as an investor, but what you should be doing is, if you have a brokerage account and, by the way, I say brokerage account because this isn't something that you would do in an IRA or a 401K or Roth IRA, where there are no tax benefits or disadvantages of buying or selling funds. It's all tax free, at least tax deferred but in a brokerage account, this is where you want to be taken advantage, ideally, of some of the market downturns. So what we do is we have funds that we would set aside or that we would identify for a client portfolio to say here's the funds we think make most sense for your portfolio to accomplish your unique goals. We also have replacement funds for those funds. We know ahead of time that Taxless Harvesting, at some point at least, is going to be a likely thing that we do for many clients. So whatever fund we have, we have replacement funds that we say, if we're going to Taxless Harvest, we know in advance what fund are we going to harvest into. So I'll walk through an example. Let's assume that we make a purchase for $100,000 in a client's account into a small company mutual fund or ETF. I'm going to use Vanguard as an example, since many people are familiar with them. Again, this is not a recommendation, but let's assume that we purchased $100,000 worth of the Vanguard Extended Market ETF. So this is a fund that's owning small companies and medium companies here in the United States. Well, that fund is based upon a Standard and Poor's index composition. So when you look at an index the S&P or the Russell 1000 or the Wilshire 3000 or the FTSE index these are all indices that are measuring the market based upon different types of composition. How are they tracking whether something's large or small, or value or growth? What are they trying to own between large or small, or value or growth, or international or domestic, or whatever the case might be? So I'll come back to this in just a second. But going back to the example, if we purchase $100,000 of the Vanguard Extended Market ETF and then subsequently small companies and medium sized companies here in the United States drop in value, let's assume that that $100,000 is now worth $90,000. Well, if you don't sell it number one it's not a loss and we have hope that it will recover. But number two, if you don't sell it, you're not able to lock in any of those losses. There's no tax benefit for doing so. So here's what you might think about doing for Taxos Harvesting when this happens. Let's assume we sell that fund, we sell the Vanguard Extended Market ETF and we use that to purchase a different fund. And let's assume that the fund that we purchase is called the Vanguard Russell 2000 Index Fund ETF. Now what does that mean? It means that it's tracking the Russell 2000, which also happens to be small and medium companies. So as you're looking at that you're getting similar exposure to the Vanguard Extended Market Index, but it's based upon a different market composition. Now, I'm not saying this as a recommendation, so talk to your financial advisor, talk to your CPA if you actually want to know if these two funds could be replacements or if they're too similar. But I'm simply using this as an example to illustrate the point, because here's what you could then do you sell the Vanguard Extended Market Index, you purchase the Vanguard Russell 2000. Index, in this example, for illustrated purposes only, and that locks in a $10,000 loss that you can now use on your tax return, but you've maintained similar exposure. And Tim, back to your question I think this is the missing piece is you didn't get the benefit just in terms of now you have a loss that you can use in your tax return, but the benefit is you remain still invested. You remain invested in something that, when small companies or medium companies do rise again, well, you're still participating in that. So theoretically, you're not missing anything, or at least you're not missing much in terms of the expected recovery, but you're still able to harvest or reap some of those tax benefits along the way. Now here's what you do next. Let's see what happens next? Well, from there, does the market continue going down? Does a small and medium size US company market continue to drop in the US? Well, if that's the case, then after 30 days, because again, you can't repurchase a similar security or the same security within 30 days without triggering a wash sale. But let's assume that the new fund you purchased continues to drop. So it goes from 90,000 and let's assume it drops to 85,000 after 31 days. Well, now you're in a position where you could actually tax us harvest again right back into the original security. So in that example, you started with 100,000. And that 100,000 was giving you exposure to the exact type of investment you want exposure to for your specific goals. Then it dropped in value, so you sold that investment and purchased a similar one to take advantage of the tax benefits. Well, the similar investment also dropped in value and the 30 plus day window expired for your ability to repurchase the original fund. Well, great, you sell the replacement security and get back into the original one. And now what's happened is you have the same allocation you otherwise would have. You have the same dollar amount in that allocation that you otherwise would have. But now you have $15,000 and losses that you've harvested without losing your exposure to that investment. That's not always the case, though. Sometimes, after you do tax us harvesting, the market increases in value and although that's very good thing, that's what we want, of course. This is why it's really important that you do the work upfront to identify the replacement security, because if you get in a situation where you tax us harvest and do a replacement security and the value that replacement security rises, in many cases you don't necessarily just want to sell out of that right away for at least 365 days, because otherwise you're dealing with a short-term gain. So you want to make sure you're really comfortable owning that replacement security, potentially for a good while in your portfolio, because you may get stuck in this position where it increases in value. You don't want to sell it because you don't want to trigger any short-term gains, but then you start to realize you know what. That really wasn't the best security that I could have purchased to replace what I originally had. So, all that to say, make sure that you're doing the work upfront. But that's the concept of how it works. Okay, that was a long-winded explanation of how this thing actually works, how the strategy actually works. Let's now talk about the benefit, because there's some misunderstood benefits to this, and it can actually be used in some pretty substantial ways. So we always have to ask ourselves why are we doing this? What's the benefit of it? Well, number one any losses that we realize through capital loss harvesting can be used to write off gains. The way that works is you may have short-term losses, you may have long-term losses. Both can be used to offset gains. The way that it works, though, is any long-term losses must first be used to offset any long-term gains. If there's excess losses above and beyond that, then that can be applied to short-term losses. Same thing as vice versa Short-term losses must be used to offset short-term gains first. So the first benefit is you can use the losses to write off capital gains in the same year that you realize the losses. The second benefit is you can actually use up to $3,000 per year of capital losses to offset ordinary income. Now, $3,000 is not a huge amount, but from impact per dollar perspective, this is actually the bigger benefit. Let's go back to Tim's question to illustrate what I mean. He mentioned someone that had a $200,000 per year taxable income, married filing jointly. What a taxable income of $200,000 per year. Your ordinary income tax bracket would be 24% at the federal level, but your capital gains tax bracket would be 15%. So if given the option, I'd rather be able to use capital losses to write off ordinary income and save $0.24 on the dollar than to use the same capital losses to write off capital gains and save $0.15 on the dollar. So it would be great if you could use this to write off unlimited amounts of ordinary income, but you are capped at $3,000 per year. So if you have $100,000 per year of income and let's say you have $10,000 in losses, you can use $3,000 of that to write off your ordinary income and bring that down to $97,000. The rest would either need to be used for capital losses or carry forward to future years. And that's another important point Is these capital losses they don't all have to be used this year. You can actually bank these losses to use against future gains. Here's a practical example of how that works out. We have many clients that will either sell a business, or they'll sell a piece of real estate, or they'll sell something that's not even in their brokerage account. Well, in those years, one of the things that we're doing from a strategy standpoint is we're trying to harvest as much as we possibly can from their brokerage account to offset the tax impact that selling their business might have on their taxes or to offset the impact that selling a piece of real estate might have on their taxes. So capital losses the IRS isn't necessarily care about. Is this a business that you sold? A piece of property that you sold, a stock that you sold, a mutual fund that you sold? They're treated the same way. A capital loss can be used to offset a capital gain and there's no limit to how much that can be applied. And I say no limit because it's said to them the ordinary income side. You're limited to writing off $3,000 per year of capital losses against ordinary income. Well, if you realize the capital loss of a million dollars, you can use that full million dollars up to a million dollars of capital gains. There's no limit to how much of that can be used in any given year and any unused losses just carry forward to future years. Here's an important note as well A lot of people will look at something and maybe, for example, they started investing 15 years ago and they've just been buying a total stock market index ever since then, and they'll look at their fund and they'll say, oh geez, we only have one investment and if you look at this, we don't really have losses. What we paid, what we purchased, is significantly less than what this investment is now worth. Well, that might be true if you're just looking at the total value of your investment compared to the total cost basis. But ideally what you're doing, if it makes sense, is you are looking at tax loss harvest, even at the individual lot level. So let's look at an example of what I mean by that. Maybe you started investing 15 years ago. Every single month you've been putting money into the same exact mutual fund ETF stock. Whatever the case might be, well, that original purchase probably has a huge gain because in the last 15 years, the stock market has grown tremendously. So you might not want to sell that specific lot. So the specific dollars that you started with, but any contributions you've made since that time, any dividends that have been paid and reinvested since that time, any one-off contributions you've made since that time, those all have their own individual tax lots. So, even if your investment as a whole has gone up in value, make sure that you're also looking at the individual lots to see are there any losses within this fund or the stock or this position that I can also sell. One rule that you need to be very careful to know as you're doing all this is you have to coordinate. Let's say that you're purchasing Vanguard's S&P 500 ETF and let's assume that there's a loss in that. Well, you go and you sell that ETF and your tax will count to realize the loss and you say well, wait a minute, why don't I just realize the loss here and then go to my IRA or my Roth IRA and purchase the fund there? So I'm still maintaining exposure. I'm not violating any wash sale rules. So I think in my brokerage account. Well, in the IRS's eyes you are. So if you buy that security anywhere, if you buy it in your IRA, if you buy it in your Roth IRA, if you buy it in another account that's not tied to this one, that still violates the wash sale rule. And here's actually where people get more hung up. It's within 30 days that you cannot purchase that same security once you've sold it if you want to be able to realize the losses. An honest mistake that a lot of people make is they will have purchased the security 30 days prior to potentially selling, so it's not just after you've sold that you have to wait 30 days, but if you've even purchased that security within 30 days prior to selling, that also triggers a wash sale violation. So be careful what you do before you realize a capital loss and after you realize a capital loss. So, as we start to wrap up today's episode, one of the things I want to point out is, while this is a relatively straightforward strategy and you can see the benefits of it, it can be done and there can be mistakes around this. So make sure you're being very careful. And the last thing that I'll say here is that realize some years. It may actually be more beneficial to realize gains than it would be to realize losses, and this is especially more common in your retirement years. Here's what I mean by that. If, in 2023, you file taxes as single, then you can have taxable income and, by the way, taxable income is your just a gross income minus your deductions. If you're single in 2023, then you can have taxable income of up to $44,625 before you pay any federal capital gains taxes. If you're married, finally and jointly in 2023, you can have taxable income up to $89,250 before you pay anything in federal capital gains. So if you're under those thresholds, tax loss harvesting probably isn't doing anything for you. In fact, it might be counterproductive. It may be better in those instances to actually be intentionally realizing gains up to a certain level, because in many cases you can do that and not pay any taxes for doing so. So make sure that you're not just doing this blindly, make sure you're not just doing this because you heard it on podcasts, but make sure you're understanding your strategy, what your goals are, what your unique tax situation is, and then make the decision that's best for you. So, Tim, going back to your question, thank you very much for providing that. I hope this was helpful to see how, yes, there are real benefits to tax loss harvesting, but you need to be mindful of your situation first. Thank you, as always, to all of you who are checking in and listening in. Make sure you watch us on YouTube as well. The channel name is James Cannell. Please leave a review, if you've not already done so already here on this podcast, and I'll see you all next time. Thank you for listening to another episode of the Ready for Retirement podcast If you want to see how root financial can help you implement the techniques I discussed in this podcast. Then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember nothing we discussed in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.

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