Tax loss harvesting – the ultimate return policy

Tax loss harvesting – the ultimate return policy

Tax loss harvesting (TLH) is a tax minimization strategy for taxable brokerage accounts. This post describes the method, the mathematical benefits, and the mental benefits of TLH. The mental benefits of this investor’s “return policy” may only apply if you’re irrational like me.

The method

A number of other resources explain TLH nicely:

That being said, I won’t rehash it in detail, but only provide a short summary of the steps:

  1. Sell an investment “A” that has lost value since you bought it. The investment needs to be in a taxable account; you don’t report capital gains or losses in tax-advantaged accounts such as 401(k)s and IRAs.
  2. Buy a similar, but not “substantially identical” investment “B” to maintain market exposure and asset allocation.
  3. Avoid buying any of investment “A” 30 days prior to and subsequent to step 1. This applies to all investing accounts, not just the one being used for TLH. (The 30 days prior requirement doesn’t apply if you sell all of your positions in “A” in all accounts during step 1).
  4. 31 days after step 1, sell “B” and re-buy “A,” assuming you have a slight preference for investment “A.”
  5. On your tax return, report the capital loss from selling investment “A” low after buying high.
  6. Use the capital loss to offset other gains or income (see next section).

The mathematical benefits of tax loss harvesting

The capital losses realized by TLH can be applied to offset the following:

  1. Short term capital gains – taxed at your marginal income tax rate (10% to 37% in 2019).
  2. Long term capital gains – taxed at rate that depends on your income, but is generally lower than the marginal income tax rate (0%, 15%, or 20% in 2019). There is also a 3.8% net investment income tax that may apply depending on your modified adjusted gross income.
  3. Up to $3k per year of ordinary income – same income tax rate as #1 above.

Short term losses first cancel out short term gains, then long term gains, then ordinary income. Long term losses first cancel out long term gains, then short term gains, and then ordinary income. Both types of losses can be carried forward to offset gains and income in future years.

For this post, I am particularly interested in TLH to offset ordinary income. If you’re in the 22% tax bracket and offset $3k of ordinary income, you’ll save $660 on taxes. You can immediately invest that money for additional returns.

But there’s one small caveat. Tax loss harvesting to offset ordinary income does not necessarily eliminate taxes. It may only defer them; you have just reset the investment to a lower basis, which will increase the long term capital gains when you sell “for real” in the future. However, as the graph below shows, long term capital gains taxes are consistently lower than income taxes. This means you come out ahead by trading income tax for long term capital gains tax.

Long term capital gains rates are lower than income tax rates
Marginal tax rates for married filing jointly in 2019 showing that long term capital gains are taxed at a lower rate than ordinary income. Income tax rates were found here, and long term capital gains tax rates were found here. For simplicity, the graph does not show the net investment income tax of 3.8% that may apply depending on modified adjusted gross income (above $250k for married filing jointly in 2019).

Furthermore, your future income (and long term capital gains) tax rate in retirement will almost certainly be lower than in your working years; while working, you not only have to cover your annual expenses, but you also have to save for retirement. Once you’re retired, the savings burden disappears and you can drop to a lower income (and long term capital gains) tax bracket.

Ultimately in retirement or low income years, you’ll be able to use capital gains to strategically “fill up” the income brackets and control your long term capital gains rate. For example, if you keep your taxable income below $78,751 (in 2019 for married filing jointly), you don’t pay any long term capital gains tax. This eliminates the extra capital gains tax that would have been due as a result of the drop in basis from TLH. In other words, after tax loss harvesting now, you can reset the basis to the original basis (or even higher) in the future for free by tax gain harvesting.

This is only a demonstration to show how TLH can lower your taxes. See this Kitces post for a detailed explanation of how long term capital gains stack on top of ordinary income for tax purposes.

The mental benefits of tax loss harvesting

Of course when investing, you hope the investments go up rather than down. But that doesn’t always happen. The section above describes how you can claw back some of the losses by sharing them with the IRS. But for me, knowing I have the possibility to TLH actually helped me invest in a taxable account in the first place.

Losses hit harder than gains

In Fooled by Randomness, Taleb makes the observation that psychologically, changes in wealth matter more than absolute wealth. This is called anchoring, and it instills a path-dependence to wealth accumulation. He further notes that losses matter more than gains; it would be better receive $700k in a lump sum than to receive $1 million and lose $300k to end up at the same $700k. As illogical as it is, anchoring definitely affects me. I am more loss averse than I’d like to be.

Tax-advantaged accounts reduce loss aversion

Since I know we want to retire, I know we need to invest. We preferentially invest in tax-advantaged accounts (401(k)s, HSAs, and Roth IRAs), as you can see in our Investor Policy Statement. There are plenty of legitimate reasons to invest in these accounts, but I can’t help but think loss aversion plays a significant role.

The 401(k)s and HSAs have employer matching. That means if I lose money, I can convince myself I haven’t lost “my money.” I view any losses as first coming out of the employer match, not my contributions. That’s completely irrational since money is fungible, but nonetheless here we are. For Roth IRAs, there is no employer match. But I can convince myself that completely eliminating future taxes offsets much of the risk of short term loss.

Tax loss harvesting also reduces loss aversion

Before learning about TLH, I was reluctant to invest in a taxable brokerage account. If the market went down, I would lose my money and would have no mental contortions to convince myself otherwise. Younger and dumber me spent anything leftover after filling up tax-advantaged accounts, partially to avoid investment losses. This is absurd because purchases are guaranteed to lose money due to depreciation. At least investments on average appreciate in value, even if the ride is sometimes bumpy. But thankfully, TLH has reduced my loss aversion to the point where we finally have investments in a taxable brokerage account. See our 2018 Financial Summary.

Hopefully we don’t need to TLH very often, since it means our investments have taken a dump. But if it happens, at least we know how to make the best of it.

Disclaimer: Tax laws and tax brackets change, and I can’t guarantee the accuracy of the statements in this post or in the linked pages. You must discuss all tax and investment strategies, including tax loss harvesting, with a trusted adviser to see if they are appropriate for you. I am not a tax or investment professional, and am only sharing the benefits of tax loss harvesting that I perceive and for my situation.

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