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Hey everyone, every week, in addition to this podcast, I write and send a concise, educational article.

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Ok, onto today’s show.

Tax-Loss Harvesting: The 5 Things You Need to Know

Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m kicking off a multi-part series on tax loss harvesting.

In part one, I’m breaking down:

• What tax loss harvesting is (and how it works)
• How to avoid getting in tax trouble
• 5 little-known things to know about wash sale rules

If you’re a retirement saver ready to learn everything you need to know about tax loss harvesting, you’re going to love this episode and this series.

For all the links and resources mentioned today, head over to youstaywealthy.com/165

What Is Tax-Loss Harvesting (TLH)?

Tax loss harvesting helps turn a dip in the market into a tax deduction.

This investment strategy can help you lower your overall tax bill.

On average, we’ve added an extra 1.8% to our clients’ after-tax returns.

Those are claims made by some very popular online investing services.

And these claims, coupled with mountains of advertising dollars and brilliant marketing teams, have really put the spotlight on ttax loss harvesting in recent years.

“When you open and fund your account, our software immediately starts looking for tax loss opportunities DAILY”, says one website.

But is that really what everyone needs? Daily tax loss harvesting? And is tax loss harvesting truly as magical as some have made it out to be?

That’s what I want to explore with you in this multi-part series.

As always, before we get into the fun nerdy stuff, here in part one, I want to lay the foundation and cover some of the key concepts. I also want to highlight some of the common misconceptions and address a few nuances everyone should be aware of.

Even if you think you know what tax loss harvesting is, I’d encourage you to stick with me as I’m confident you’ll learn something new…or at the very least interesting.

To start, let’s define tax loss harvesting… in plain English.

3-Step Process for Implementing TLH

Tax loss harvesting is a 3-step process:

Step 1 – You sell a security (a mutual fund, ETF, or individual stock, for example) that has lost money and intentionally recognize that loss.

Step 2 – You use the realized loss on that investment to offset taxes you owe on another investment that made money. You might also use it to offset some ordinary income.

Step 3 – This final step is optional, and it is to reinvest the proceeds of your sale into a different security (or basket of securities) that matches up with your target asset allocation.

To recap:

1. Sell a security at a loss
2. Use the loss to offset capital gains or ordinary income
3. Reinvest the proceeds into a different investment

Again, that last step is optional.

We’ll talk about it in more detail shortly, but just know that there are a number of use cases for just selling a security (or securities) and realizing losses. Reinvesting the proceeds from that sale, while it is common, is not technically required to engage in tax loss harvesting.

Ok, so to make sure everyone is following up to this point, let’s run through two oversimplified examples of how tax loss harvesting works and what makes it a popular tax planning strategy.

Meet Tax-Smart Tom

We’ll use our friend Tax-Smart Tom to help here in the first example.

A couple of years ago, Tom decided to buy $100,000 worth of Apple stock in his brokerage account. The stock has done well, and today, it’s now worth $150,000. In other words, his investment in Apple has increased by 50% and he now has a $50,000 long-term unrealized gain. (Note, it’s unrealized because he hasn’t sold it yet. It’s just a gain on paper. When he sells it, the gain will then be realized.)

So he has this $50,000 unrealized gain, and after listening to the Stay Wealthy podcast, he is convinced that he got lucky with this speculative single stock investment, and he’s ready to sell it all and diversify the proceeds.

But as we all know, when you make money on an investment that’s not held inside a tax-advantaged retirement account, and then sell some or all of that investment, you have to pay taxes on the gain.

So if Tom went ahead and sold all $150,000 of his Apple stock today, he would pay about 20% in long-term capital gains tax on the $50,000 long term gain. In other words, it would cost him $10,000 in capital gains taxes to sell his Apple stock.

But Tom is tax-smart and he knows that there is a more tax-efficient way to accomplish his goal of selling Apple stock and diversifying.

You see, like most retirement investors, Tom doesn’t just own this one stock. He has a diversified portfolio of low-cost index funds in another brokerage account. And just over a year ago, in an attempt to get some global diversification, he bought $250,000 of an international ETF in that account.

As we all know, international stocks have had some trouble lately, and that ETF he bought has dropped by about 20%. His $250,000 investment is now valued at $200,000. In other words, he has a $50,000 unrealized loss.

Revisiting Tom’s goal of liquidating his Apple stock more tax efficiently, here’s what he can do.

Tom can go ahead and sell all $150,000 of his Apple stock just like he had planned, realize the $50,000 capital gain, and go ahead and diversify the proceeds as he sees fit.

But instead of paying the capital gains taxes, he can subsequently liquidate his entire international stock ETF and realize that $50,000 loss.

The $50,000 realized loss will now offset the $50,000 gain, and Tom will have avoided that pesky capital gains tax bill from the sale of Apple stock, all while allowing him to get more diversified.

However, there’s still a problem that you’ve likely identified.

While Tom avoided paying capital gains taxes on his Apple stock liquidation, he now has $200,000 sitting in cash from the sale of his international stock ETF.

He certainly doesn’t want this money just sitting in cash, and he would love to maintain his international stock allocation so his portfolio stays in line with his investment policy statement.

Unfortunately, Tom can’t just take the $200,000 of cash and immediately reinvest it back into the international stock ETF he just sold. This would trigger what’s known as the Wash Sale Rule.

In plain English, the wash sale rule says that if you sell a security at a loss (like Tom’s international stock fund), you cannot buy it back within the next 30 days. But here’s the kicker: You also can’t buy a QUOTE “substantially identical” security.

In other words, Tom can’t buy another international stock fund that, more or less, looks very similar to the one he just sold.

So Tom has two options here:

Option 1 – Tom can keep his $200,000 in cash, wait for the 30-day wash sale period to end,  and then go ahead and buy back his original international ETF. But Tom is a smart investor, and he knows that “time in the market” is really critical, and missing even a few days of good returns could take years to recoup. So he doesn’t want his cash just sitting there doing nothing.

Which leads him to Option 2…

Option 2 – Notice that the IRS uses the term “substantially identical.” And when it comes to individual stocks and bonds, applying this term is pretty straightforward. For example, you can’t sell Tesla stock and loss and then immediately repurchase Tesla stock without triggering the wash sale rule. It’s pretty obvious that buying the same stock you just sold would be substantially identical.

But, as you might imagine, things get a bit murkier when you’re dealing with a pooled investment like an ETF or mutual fund, and that’s largely because the wash sale rules weren’t really written or intended for these investment vehicles.

For example, what exactly causes two ETFs or mutual funds to be substantially identical? Percentage of security overlap? Correlation? Name of the fund?

While the IRS hasn’t provided additional guidance here, most experts have come to the conclusion that, for now, there is more flexibility than there probably should be with ETFs and mutual funds.

The Wash Sale Rule

Let’s use Tom’s situation to illustrate.

Let’s say that the international stock index fund Tom sold was the iShares Core MSCI EAFE ETF, the ticker symbol is IEFA. This index fund specifically tracks the MSCI EAFE index.

Tom – if he and/or his trusted advisors agree on a more liberal interpretation of the wash sale rule – could consider using his $200,000 of cash to buy another international index fund from another fund company that more or less maintains the international exposure he’s looking for.

For example, let’s say he chooses Vanguard’s international ETF, the ticker symbol is VEA. Tom and his trusted advisors might determine that VEA wouldn’t trigger the wash sale rules because it technically tracks a different index — it tracks the FTSE Developed International Index instead of the MSCI.

While most would probably sign off on this, given that it’s two different fund companies and two different indexes being tracked, if push came to shove, one could certainly argue that those two funds are still “substantially identical” given that they are both low-cost international index funds that are highly correlated and have very similar underlying holdings.

Given that, if Tom didn’t feel like pushing the limits with the wash sale rule and taking the risk – but still wanted to maintain exposure to international stocks – he could consider maybe buying an actively managed international fund that doesn’t track a specific index and contains substantially different holdings.

It will, of course, be more expensive to own an actively managed fund, and he certainly runs the risk of underperforming his desired index, but maybe these downsides outweigh the alternative of sitting in cash on the sidelines.

Plus, it’s only for 30 days, and after the 30 days is up, he can swap his higher-cost actively managed fund for his low-cost index fund and continue moving forward with his investment plan.

The wash sale rule exists to prevent investors from using tax loss harvesting to save money on taxes without the investor changing his/her economic position.

One could likely argue that an actively managed international fund, with less overlap, lower correlation, and higher fees, is substantially different than the fund he sold and Tom’s economic position will most certainly change.

Sure, he could get lucky during those 30 days, and his active fund could outperform his original index fund, but on average, the odds would lean towards the opposite happening.

Ok, we ran through a lot, so let’s summarize Tom’s successful execution of tax loss harvesting before moving on. Tom was able to sell all $150,000 of his concentrated Apple stock,  avoid the capital gains tax by selling his entire international fund at a $50,000 loss, reinvest all of the proceeds while navigating the wash sale rule, and maintain his desired asset allocation.

But, as I mentioned, this is just one example of how an investor can use tax loss harvesting to manage their tax bill.

Tom didn’t really harvest any losses. He just sold a security at a loss to offset the taxes owed on a security he sold with a gain, and then navigated the wash sale rules to, more or less, keep his investment plan intact.

The other way an investor can engage in tax loss harvesting is to proactively sell securities at a loss, even if there aren’t any capital gains that those losses can be applied to. These losses are “harvested” and saved for use in a future year; the technical term for this is “tax loss carryforward.”

These harvested losses can either be used to:

• Offset up to $3,000 of ordinary income in a given year
• Offset future capital gains

One of the biggest attractions – while it may not be as valuable as some think – is that these harvested losses never expire. We’ll talk more about this in a future episode in this series.

So here’s how this works…similar to our first example with Tom, the process would involve selling a security (or securities) at a loss and then navigating the wash sale rules to reinvest the proceeds without straying from the investor’s desired asset allocation.

In other words, most long-term investors wouldn’t want to sell some or all of their international stock fund at a loss, and then put that money in cash or buy a completely different asset class, like a U.S. stock fund,  just to get around the wash sale rule.

That would cause them to have a higher % of U.S. stocks or cash than they intended. And I realize it’s just for 30 days, but most smart investors who have a target asset allocation don’t want to be overly concentrated in one asset class for an entire month.

So, again, depending on their interpretation of the wash sale rules, these investors or their advisors would proactively sell securities held in a brokerage account at a loss, harvest those losses, and immediately reinvest the proceeds in a security or securities that are similar but not “substantially identical” in the IRS’s eyes.

They would sell some or all ofl an international index fund tracking the MSCI index at a loss and immediately use the proceeds to buy a Vanguard international index fund tracking the FTSE index. And then after 30 days, buy back the fund they originally sold and enjoy the losses they harvested along the way.

We’ll talk more about the pros and cons of this in an upcoming episode and how to decide if proactive tax loss harvesting makes sense for you, but for now, just take note of what’s happening here from a tax standpoint.

When you harvest losses, the cost basis of your portfolio is reduced by the amount of the loss. So, you might have received a near-term benefit from doing tax loss harvesting, but at the same time created future gains, that when realized, wipe out most or even all of that benefit.

My friends at Alpha Architect summed this up pretty well by saying the following:

“The taxes saved today will simply end up being paid in the future because proceeds from sales are reinvested into other assets, which will hopefully be sold at a profit and eventually taxed. The benefit of tax loss harvesting, if there is one, is tax deferral, not tax avoidance.”

I’ll be diving into this whole concept later in this series. For now, just something to think about as we build on the concepts learned today.

Speaking of those concepts, once again, everything I shared today was intentionally overly simplified, and like most things we cover on this show, there are dozens of nuances, rules, and unique situations to be aware of. And don’t worry, we will be getting into some of those nuances.

The 5 Things Every Retirement Saver Needs to Know

But to round out part one of this series, I’ve pulled together what I think are 5 little-known things everyone needs to know about tax loss harvesting and the wash sale rule.

1.) The wash sale rule applies to ALL of your investment accounts, at every institution, including retirement accounts like IRAs. For example, if you sell Vanguard’s international fund, VEA, at a loss in your Schwab brokerage account, and then immediately buy it back in your Fidelity IRA thinking you were clever, you will trigger the wash sale rule and not be allowed to write off the investment loss. In some cases, regulators can also impose fines or restrict trading.

2.) The wash sale rule also applies to your spouse’s accounts. In other words, I can’t sell a security for a loss in my account and then immediately buy the same security – or a substantially identical one – in my wife’s account.

3.) The wash sale rule is NOT confined to the calendar year. For example, you can’t sell a security at a loss at the end of December and then immediately buy it back in January when the calendar turns to avoid the wash sale rule.

4.) Tax loss harvesting and the wash sale rule apply to all securities with a CUSIP number. The example I shared involved ETFs and mutual funds, but the wash sale rule also applies to individual stocks, bonds, and even options. So, get this… if you sell a stock at a loss, and then try to get sneaky and immediately buy a call option on that same stock, you will trigger the wash sale rule.

5.) In my examples today, we were only working with long-term gains and losses – securities held for longer than one year. As you know, long term gains receive better tax treatment than short term gains, which are taxed as ordinary income (i.e., they are taxed just like the paycheck from work). Here’s why this is important to take into consideration with regards to tax loss harvesting.

Short and long-term losses must be FIRST used to offset gains of the same type.

Only if losses of one type exceed gains of another type are you able to apply the excess to the other type.

Kind of confusing, so let’s look at a quick example. Let’s say you sold XYZ stock today and realized a $15,000 long term loss. Let’s say you also sold a few other securities that made money, and in doing so, you realized $15,000 of long term gains as well as $15,000 of short term gains.

Unfortunately, your $15,000 long term loss must be applied to the $15,000 of long term gains first (i.e., the same type),which is helpful, but still leaves you with $15,000 of higher cost short term gains, which most investors would have preferred to wipe out instead. If, on the other hand, you had $30,000 in long term losses, the first $15k could have been applied to the long term gains and the remaining $15k, the excess, could then be applied to the short term gains.

Given this often overlooked rule, it’s important to pay close attention what type of losses you’re harvesting. Because, again, short term gains typically come with a higher tax bill than long term gains. The least effective use of any short-term losses you harvest is to use them to offset the more favorable long term gains. You would typically want those short term losses to offset the more expensive short term gains instead.

Again, there are a ton of “it depends” type situations here…the takeaway is to be aware of the type of losses and gains you’re dealing with so you can maximize the tax benefit of this strategy.

To recap, these 5 things everyone needs to know:

1. The wash sale rule applies to ALL of your investment and retirement accounts at ALL institutions
2. The wash sale rule applies to both your accounts and your spouses
3. The rule is NOT confined to the calendar year – 30 days is 30 days
4. The rule applies to all securities with a CUSIP, including stock options
5. Short and long-term losses must be used first to offset gains of the same type

One final reminder here to avoid any confusion: Remember that the IRS only cares about losses with regard to the wash sale rule. If you want to sell a security for a gain – maybe to take advantage of something called tax gain harvesting – and then immediately buy the same security back again, go for it.

In fact, the IRS would love it if you regularly did that because, in most cases, they get to collect some tax money when investments are sold for a profit.

Once again, the wash sale rule exists to prevent investors from using tax loss harvesting to save money on taxes without changing their economic position. In case you missed it, I did an episode on tax gain harvesting last year, which I’ll link to in the show notes if you want to check it out.

Ok, with the foundation laid down for tax loss harvesting, we’ll move into part two next week, where I will get into some of the technical weeds. I’ll be talking more about how to maximize the benefits of tax loss harvesting, who it’s a good fit for, who it’s not a good fit for, mistakes to avoid, and more.

To grab the links for today’s episode, head over to youstaywealthy.com/165

Thank you as always for listening, and I will see you back here next week.