It’s been a while and today I am back with a pretty technical topic but it is a topic that can make a big difference in your returns. The topic of the day is Tax Loss Harvesting. In its basic definition, this consists of selling an investment (like stocks/ETFs/ Mutual Funds) at a loss. Why? So you can use the loss to offset a gain in some other investment. While you sell you loser investment, you also buy something very similar. This way, you maintain your desired asset allocation while paying less in taxes. Remember that portfolio of 80% stock and 20% bonds we originally established? That’s your allocation.
By now, you are probably thinking: “Why in the world would you torture me with such a boring topic?” Here are a few reasons. #1: It is a really good way to pick up extra returns = make more money (read on for more on this one). #2: It is 2016 and there is no excuse not to do it. And #3: It will take 10 minutes to read this and you will learn something new that might help you make more money in the future. The younger you are when you start doing this and the higher your tax bracket is, the better your life will be as a result.
The tax loss harvesting works best with funds. A large cap funds? Well, I am pretty sure I can find another one that is not that different from the one I just sold. Individual stocks? Selling Apple and buying something really close to Apple that’s not Apple? That’s harder to do.
Sounds like I am on my way to paying less taxes. Ssssweeett. But you need to remember that (1) your investment losses can offset up $3k of ORIDNARY taxable income per year and (2) the IRS has caught up to you and you cannot engage in a “wash sale” (more on this later) when you sell and buy back a “substantially identical” investment.
Ok, fine, sounds important. So how do you actually engage in loss harvesting? You get involved with a robo advisor and let them do it for you. You do not do this manually! To max your losses and increase efficiency, you need to do it EVERY DAY. Some advisors will sell you this service but unless they outsource it to a robo advisor (like I do), it is impossible for a human to compete with a machine.
What does this mean in terms of returns and is this whole exercise worth it? It will depend on your portfolio and market conditions but Betterment (which I do use in my practice and which I think has a one of the best, if not the best tax loss harvesting out there) estimates that for a 70% stock portfolio, harvesting adds about 0.77% in return per year. Some estimates go as high as 1.30% (for a much larger account). When you are paying an advisor 0.75%-1%, getting back 0.77% in tax loss harvesting, that is pretty amazing. Throw in the effect of rebalancing, and you pretty much get someone to manage your money and do your financial planning for free.
Now, here comes the hard part. You didn’t think it was this easy, did you? Here are a few things to be aware of
1. Avoid short term capital gains. Here is the dilemma and what happens. First, if you sell something and buy it back within 30 days, the IRS does not consider the loss. This is called a wash sale. Let’s say Apple dipped by 10% in a day. You sell it and plan to use the loss to offset some gains. 2 weeks later, you change your mind and buy some shares of Apple. Well, your 10% loss is no longer a loss. You have now created wash sale and the IRS treats the loss like it has never happened.
So you are thinking: “Great, I will just wait for 30 days and buy it back but then”. But this is how you the possibility of short term capital gains, which might negate the whole point of tax loss harvesting.
Some other “smart” person might say “Let me sell the stock in my taxable account and instead, buy it in my IRA”. This is a big No, No, No. This might lead to a permanent wash sale. If you care to understand the details, just ask me privately, but if you, or the person managing your money, are not too familiar with these rules and attempt to manually tax loss harvest, you should be careful. This might result in one expensive tax loss harvest.
2.If you do not have all your accounts in one place, then it is really easy to create wash sales and get in trouble. Betterment is very good at harvesting across ALL their accounts but they still can’t trade in your IRA with Fidelity or Vanguard. This also includes spouse’s accounts.
However, just because you have the same investment somewhere else, you do not get in trouble. Problems come up when you sell something and then turn around and buy some more of a “substantially identical” security (like automatic reinvestment of dividends in your IRA).
So, be careful, don’t buy the exact same “thing” or one that is very similar. Well, what is very similar? If you sold an index fund that tracks S&P 500, don’t buy another one that tracks the same index. Go and buy something that tracks a different index.
Let’s say I convinced you, you are all for it, especially if you already have (or are considering) a Betterment account. So what happens if you turn tax loss harvesting on but have other accounts in different places? Before you turn it on, check to make sure you do not have similar ETFs/ Mutual funds you already own somewhere else and figure out what your outside investments track.
Bottom line is that tax loss harvesting can and should reduce your taxes. If you have IRAs in other places, roll them other to whoever you plan to use for tax loss harvesting. Same goes for old employer 401(k)s and 403(b)s. The problem arises when you have current 401k(s) and most of us do have those because well, because we are not ladies of leisure and we have jobs. So those current employer accounts need to be checked before you turn the tax loss harvesting on and if your advisor uses this feature, make sure she understands the implications and what needs to be check for.
One last thought. Someone asked me if they could tax loss harvest in 401(k)s and IRAs… not really. Those accounts are already tax free to tax advantage so what exactly will we harvest? The harvesting is all about taxable accounts but having IRAs and 401(k) may interfere with the harvesting success so you still need to be aware of how this whole thing works.
 Here is a good white paper by Betterment on the topic. Please be aware this is how the company does their harvesting. It may not necessarily mean that everyone does it this way: https://www.betterment.com/resources/research/tax-loss-harvesting-white-paper/
 Here is a quote from Betterment that explain this issue very well: “For example, VTI, one of the ETFs we purchase and harvest, tracks the CRSP US Total Market Index. So does the mutual fund VTSAX, also from Vanguard. Despite the fact that they are different types of investments, selling the ETF at a loss while purchasing the mutual fund inside the wash sale window could trigger a wash sale. Another example is any fund that tracks the S&P 500. The large cap funds in Betterment’s portfolio track value-tilted indexes, so a fund that tracks the S&P 500 index with no tilt should not be problematic (e.g. VFINX, VFIAX, SPY, FUSEX, FUSVX and many more).”