Tax Loss Harvesting To Defer Taxes – The Ultimate Guide

Tax loss harvesting may sound fancy and complicated, but I promise it's super simple, and you'll have a better understanding of it after reading this guide. Here we'll explore what tax loss harvesting is, why and how you'd want to do it, the rules, limits, and deadlines involved, examples, and how to avoid the infamous “wash sale” in your portfolio.

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Introduction – What Is Tax Loss Harvesting?

Tax loss harvesting just refers to selling investments at a loss to lower your tax burden. Simple as that.

Specifically, we're talking about selling positions that have unrealized capital losses at the time of sale in order to offset realized capital gains (or taxable income, if you don't have any realized gains) for that year. If used to offset realized capital gains, those gains can be short-term or long-term, the former of which are taxed at higher rates.

In other words, realized losses can be used as a credit against any realized gains during the year. We call this sale “harvesting” the loss, hence the name tax loss harvesting.

When To Tax Loss Harvest – Deadlines and Strategies

Tax loss harvesting to offset that year's gains or income must be done by the end of the calendar year, so the deadline is December 31. Naturally, this encourages many to employ a strategy of checking the portfolio at the end of the year to harvest any losses, but tax loss harvesting can actually be used anytime your position in a security has an unrealized loss throughout the year.

Day traders will use this as a tool to offset short-term capital gains. If the long term investor is simply holding and has no realized gains, their harvested losses can reduce their income tax liability.

Tax Loss Harvesting Limits, Rules, and Wash Sales

So far tax loss harvesting sounds like a great way to reduce one's tax liability. Unfortunately there are some limits and rules to abide by.

First, if the long term investor mentioned above who has no realized gains wants to harvest losses to reduce their taxable income, they can only do so up to a limit of $3,000 per year if single or married filing jointly. That is, if your realized net loss on your investments at the end of the year is $5,000, you can only deduct up to $3,000 from your taxable income for that year, but you can also carry forward the unused loss of $2,000 to harvest in the future.

Secondly, there's an important tax loss harvesting rule from the IRS known as the wash sale rule that prohibits investors from using losses to offset gains of the same security. The rule states that the investor wishing to harvest losses cannot buy a “substantially identical” security within 30 days on either side of the sale, as doing so would trigger a “wash sale” which invalidates the harvesting of the loss. This rule applies across all your investment accounts holistically. It also applies to reinvested dividends and capital gains distributions, so if you're wanting to harvest losses, you'd want to turn that off.

After you sell to harvest a loss, you can then either buy a substitute fund immediately, or hold cash for 31 days and then buy your position in the original fund again. While a bit more complicated, the former may be the more prudent move, because we know only a handful of great days for the stock market account for much of each year's performance, and those days could very well occur during that 31 day period.

But of course, in true IRS fashion, they have never explicitly defined what constitutes a “substantially identical” security, so as you can imagine, there exists reasonable disagreement on whether or not two funds from two different providers that track the same index would be considered “substantially identical.” Luckily, we can usually avoid that anyway by just using different indexes to capture the same exposure we're after.

Also remember that tax loss harvesting is only possible in taxable brokerage accounts, as the IRS does not tax growth in retirement accounts in the U.S. Thus, if you don't have a taxable account, you don't need to worry about tax loss harvesting at all.

Now let's check out some examples to see tax loss harvesting in action.

Tax Loss Harvesting Examples

Here are some examples to illustrate tax loss harvesting. The numbers for gains and losses are made up. The tax brackets and harvesting limits are real but are subject to change. Consult your tax professional. I've included the cursory math following each example.

First let's look at an example of offsetting realized capital gains with a harvested loss to simply reduce the capital gains tax liability.

Suppose Sarah has sold a position during the year for a realized short-term capital gain of $2,000 and is in the 24% tax bracket. Since short-term capital gains are taxed at her marginal tax rate, she is expecting to pay $480 in taxes on those gains at tax time. Before the end of the year, she notices another position with an unrealized loss of $1,500. By harvesting that loss, she can now offset those $2,000 in gains with it, so her short-term capital gain is reduced to $500, on which she'll now only pay $120 in taxes, a reduction of 75%.

$2,000 x 24% = $480
$2,000 - $1,500 = $500
$500 x 24% = $120

Remember short-term capital gains apply to positions sold within a year, after which they're characterized as long-term capital gains. Long-term capital gains are taxed at lower rates. Specifically, if Sarah's previous position were a long-term capital gain, she would owe 15% in taxes on it instead of 24%. If she deployed the same tax loss harvesting strategy, she would have reduced her capital gains tax liability from $300 to $75, a reduction of 60%. This illustrates that tax loss harvesting is more impactful for short-term gains, but is still useful for long-term gains as well.

$2,000 x 15% = $300
$2,000 - $1,500 = $500
$500 x 15% = $75

Now let's look at an example where the net loss is equal to the net gain.

Assume Ashley has sold a position during the year for a realized long-term capital gain of $2,000 and later notices before the end of the year that she has an unrealized loss of the same amount, $2,000. Harvesting the loss offsets the gain in full so she now has zero capital gains tax liability for the year.

For the next example, we'll look at a situation where the net loss is greater than the net gain.

Assume Ashley's unrealized loss from the previous example is now greater at $3,000 and she still has the realized long-term gain of $2,000. She can offset that gain in full and then use the remaining $1,000 loss to directly reduce her taxable income. If her long-term capital gains rate and effective tax rate are both 15%, she has saved $300 in capital gains taxes and $150 in income taxes for a total tax savings of $450.

$2,000 - $3,000 = -$1,000
$2,000 x 15% = $300
$1,000 x 15% = $150
$300 + $150 = $450

Lastly, we'll look at an example with a large loss greater than the income-offset limit and zero realized gains. If you subscribe to the Boglehead philosophy that I preach throughout this site, this is the most likely situation you'll find yourself in out of these examples.

Pretend Patrick is a long-term investor who simply invests a portion of his paycheck into his taxable brokerage account of index funds regularly and has no intention to sell to realize gains until retirement. While his account value has obviously grown over the years, he has specific tax lots (specific groups of shares bought earlier in the year) with unrealized losses totaling $5,000 after markets faltered during the year, and he has zero realized gains because he has not sold any of his positions. Remember we can use tax loss harvesting to offset income up to $3,000 per year, so Patrick can book that $5,000 loss, reduce his taxable income for the year by $3,000, and then carry forward that extra $2,000 in unused losses to use next year or sometime in the future.

Is Tax Loss Harvesting Worth It?

I've seen many ask if tax loss harvesting is “worth it” when considering the extra time and effort required, to which I'd reply:

• First, it's a very small amount of time and effort required to harvest losses each year.
• Secondly, yes a $3,000 tax write-off each year would obviously be valuable to many.
• Lastly, we showed earlier how tax loss harvesting becomes increasingly impactful as one's marginal tax rate increases.

A study from First Quadrant estimated that tax loss harvesting adds about 14% to the final portfolio value compared to one that does not harvest losses annually. For a $1 million portfolio, that would be an extra $140,000.

When You Should NOT Tax Loss Harvest

So it sounds like tax loss harvesting is always gravy all the time, right? Well, not quite.

Recognize that in selling at a loss and re-entering the position at the current price, you have now lowered your cost basis from what it was previously, which means greater gains to be taxed later in the future. Granted, those greater gains won't be taxed until you sell, so you're basically giving yourself an interest-free loan, and we'd assume a lower tax bracket in retirement with little to no income for most people. But in that sense, it's important to note that you have simply deferred taxes; you have not avoided them entirely.

So an obvious situation when it would not make sense to tax loss harvest is if you wouldn't be taxed on gains in the first place, which would happen when your income is low enough to avoid capital gains taxes altogether. This only applies to long-term capital gains, which, at the time of writing, you would avoid if your annual income is below about $40k.

How To Tax Loss Harvest – Steps

1. Turn off dividend reinvestment. Make sure you haven't bought any shares of the fund you intend to TLH in the past 30 days.
2. Sell the position at a loss.
3. Buy an alternative replacement fund (examples below) or hold cash for 31 days and then re-enter the original position.
4. Turn dividend reinvestment back on unless you plan to TLH more throughout the year.

Tax Loss Harvesting ETF Replacements

Here is a non-exhaustive list of groups of alternative index funds that you can swap out that we can be sure would not be classified as “substantially identical.”

• U.S. Total Stock Market – VTI, ITOT
• U.S. Large Cap Blend – VOO, VV, VONE
• U.S. Large Cap Value – VTV, VOOV, VONV
• U.S. Large Cap Growth – VUG, VOOG, VONG
• U.S. Mid Cap Blend – VO, SCHM, IJH
• U.S. Mid Cap Value – VOE, IWS, IVOV
• U.S. Mid Cap Growth – VOT, IVOG, IWP
• U.S. Small Cap Blend – VB, SCHA, ISCB, VIOO
• U.S. Small Cap Value – VBR, VIOV, IWN, ISCV
• Total International (Ex-US) Stock Market – VXUS, VEU, IXUS
• Developed Markets – VEA, SCHF, SPDW
• Emerging Markets – VWO, IEMG, SPEM
• U.S. REITs – VNQ, SCHH
• T-Bills – SGOV, CLTL
• Treasury Bonds – Short – VGSH, SHY
• Treasury Bonds – Intermediate – VGIT, IEF, GOVT
• Treasury Bonds – Long – VGLT, TLT
• U.S. Treasury STRIPS – EDV, GOVZ
• TIPS – Short – VTIP, STIP, STPZ
• TIPS – Intermediate – SCHP, GTIP, TIP

Conclusion

Tax loss harvesting – selling losing positions to offset gains and/or reduce taxable income – may be a useful part of your investing strategy. The tax savings from harvesting losses increase as one's marginal tax rate increases.

Plan ahead to ensure your tax loss harvesting tactics go smoothly. Follow the steps above and decide whether or not to buy a substitute fund or hold cash for 31 days.

For those using M1 Finance, note that while the broker does not specifically automatically harvest tax losses for you, their tax optimization selling algorithm does sell tax lots with losses first anytime you sell shares.

How do you approach tax loss harvesting in your portfolio? Let me know in the comments.

Are you nearing or in retirement? Use my link here to get a free holistic financial plan from fiduciary advisors at Retirable to manage your savings, spend smarter, and navigate key decisions.

Don't want to do all this investing stuff yourself or feel overwhelmed? Check out my flat-fee-only fiduciary friends over at Advisor.com.

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Disclaimer:  While I love diving into investing-related data and playing around with backtests, this is not financial advice, investing advice, or tax advice. The information on this website is for informational, educational, and entertainment purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. I always attempt to ensure the accuracy of information presented but that accuracy cannot be guaranteed. Do your own due diligence. I mention M1 Finance a lot around here. M1 does not provide investment advice, and this is not an offer or solicitation of an offer, or advice to buy or sell any security, and you are encouraged to consult your personal investment, legal, and tax advisors. All examples above are hypothetical, do not reflect any specific investments, are for informational purposes only, and should not be considered an offer to buy or sell any products. All investing involves risk, including the risk of losing the money you invest. Past performance does not guarantee future results. Opinions are my own and do not represent those of other parties mentioned. Read my lengthier disclaimer here.