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Listen to the Podcast Here: 5. Tax-Loss Harvesting

As we wrote in our last post, it hasn’t been very fun in the stock market so far this year. As of the stock market close today (May 18, 2022), the S&P 500 is down 17.68% year-to-date. While we never like to see our portfolios go down, as the saying goes, “When life gives you lemons, make lemonade”.

Selling Securities at a Loss

We sold mutual funds and ETFs for clients last week that resulted in over $158,000 of losses and we’re actually pretty happy about it. If you’re not taking advantage of this strategy when the market is down big, then you’re missing out on great tax benefits.

Here’s why:

When the stock market goes down it generally (historically) doesn’t stay there.

Sure, it could stay down for a while, but when you zoom out you see that the chart for the S&P 500 generally goes up and to the right.

In fact, history tells us that we should expect an average of a 14% drawdown in the S&P 500 every year. Despite that intra-year decline, between 1980 and 2021 annual returns for the S&P were positive in 32 of those 42 years – over 76% of the time.

Tax-Loss Harvesting

Enough baiting an statistics. The strategy that we’re referring to is called tax-loss harvesting (TLH). Here’s a high-level explanation of TLH from Fidelity:

“Tax-loss harvesting allows you to sell investments that are down, replace them with reasonably similar investments, and then offset realized investment gains with those losses. The end result is that less of your money goes to taxes and more may stay invested and working for you.” – How to cut investment taxes, Fidelity

The first thing that you should know is that tax-loss harvesting only applies to securities in a taxable brokerage account. Since realized gains in pre-tax and Roth accounts are tax-deferred, you cannot benefit from TLH in those types of accounts.

Why Sell at a Loss?

The reason that you would consider selling a security at a loss (and be happy with that decision) is because you can (potentially) use the loss to offset capital gains.

Why do we say ‘potentially’? Because, of course, there are rules that you have to play by.

For example, if we sold a stock, mutual fund, or ETF at a loss of $100,000 and sold a different one at a gain of $50,000, then the gain would be offset by the loss and there wouldn’t be any taxable income.

Notice that there would still be $50,000 of losses leftover. You can use $3,000 of that leftover loss to offset your ordinary income (employment income) and the remaining $47,000 would carry over to next year.

Next year, we could take $47,000 of gains and not pay any taxes on them since we have the carryforward loss.

The Wash Sale Rule

Now for the rules. You have to be sure not to create a wash sale.

Here is a great explanation of the wash-sale rule from Fidelity:

“The rule of a wash-sale prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale. If you do have a wash sale, the IRS will not allow you to write off the investment loss which could make your taxes for the year higher than you hoped.” – Wash sale: Avoid this tax pitfall, Fidelity

Remember that the market goes up the majority of the time? Rather than selling at a loss and staying in cash for 31 days, you probably want to stay in the market given that it generally goes up over time.

Let’s say we sold ETF XX at a loss. Rather than buying back ETF XX to make sure that the client’s funds stay invested, we purchase ETF YY.

ETF XX could be a large cap value fund from Company A that tracks an index while ETF YY could be a large cap value fund from Company B that tracks a different index. Since these funds are from different companies and they track different indexes, the general consensus in the financial planning community is that they are considered different enough to not cause a wash sale.

(Please note that the wash sale rule was created with individual stocks and bonds in mind before mutual funds and ETFs were in existence. The IRS has never provided any formal guidance on the wash sale rule for ETFs and mutual funds.)

The Wash Sale Rule Applies Across Your Entire Portfolio

Not creating a wash sale can be really tricky to work through when you have multiple accounts because you need to make sure not to trade a substantially identical security within any of the accounts 30 days before or after the sale.

Once 30 days has passed, you can look back at the portfolio and see if it makes sense to trade back into your preferred securities or keep the ones that you bought as a result of the tax-loss harvesting.

When Should You Take Advantage of Tax-Loss Harvesting

There’s no rule that says, ‘you should take advantage of tax-loss harvesting when a security is down X%’. Part of the consideration of whether or not taking advantage of tax-loss harvesting is worth it is ‘return on hassle’.

If you have a brokerage account with $500 and the value drops by 10%, is the hassle of tax-loss harvesting a $50 loss worth it to you? What if that account value is actually $5,000 and the loss is 5% (or $250)?

That answer will be different for everyone.