Have you joined the Stay Wealthy newsletter?
No spam. No fluff.
Just one retirement/tax planning article each week…written by yours truly. 😊
Join thousands of other retirement savers and receive my weekly retirement email.
Tax-Loss Harvesting (Part 3): Answering Three Common Questions
In this episode of the Stay Wealthy podcast, I’m wrapping up our tax-loss harvesting series.
Specifically, I’m answering three (3) common questions:
- What if I don’t have any capital gains to offset? How to maximize the benefits of tax loss harvesting?
- How do I navigate multiple tax lots properly and avoid making a costly mistake?
- What is direct indexing and why is tax-loss harvesting always advertised as a benefit?
If you’re a new listener, hit the pause button on today’s episode and go listen to part one of this series first.
How to Listen to Today’s Episode
🎤 Click to Listen via Your Favorite Podcast App
- Subscribe to the Stay Wealthy Newsletter! 📬
- Tax-Loss Harvesting Series:
- ETF Examples:
- Capital Loss Carryforward [H&R Block]
- Why Tax-Loss Harvesting During Down Markets Isn’t Always A Good Idea [Ben Henry-Moreland]
- What is Tax Lot Accounting [Investopedia]
- Direct Indexing
- Drawbacks of Direct Indexing [ThinkAdvisor]
- The Mirage of Direct Indexing [CFA Institute]
Tax-Loss Harvesting (Part 3): Answering Three Common Questions
Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m wrapping up our tax-loss harvesting series by answering 3 final questions; what if I don’t have any capital gains to offset, how do I maximize the benefits of tax loss harvesting, how do I properly navigate multiple tax lots and avoid making a costly mistake, and what is direct indexing and why is tax-loss harvesting always advertised as a benefit?
If this is your first time listening to this podcast, hit the pause button on today’s episode and go back to part one of this series which aired a few weeks ago on August 24th.
I’ll link to it in the show notes, in addition to other helpful articles referenced in today’s episode, which you can find by going to youstaywealthy.com/167.
Repeat after me:
If there is any benefit to doing tax loss harvesting, it is from deferring the taxes you owe, not avoiding them.
One more time:
If there is any benefit to doing tax loss harvesting, it is from deferring the taxes you owe, not avoiding them.
I want that to be the main takeaway of this series.
Because, yes, tax-loss harvesting can certainly be a great tax strategy and it can lead to higher after-tax returns and help you keep more of your hard-earned money.
But it’s not as simple as just selling some securities at a loss.
And it’s not the riskless no-brainer that many claim. In fact, in many cases, there is no benefit to pursuing this strategy at all. Even worse, tax-loss harvesting can sometimes have a negative effect.
While it’s impossible to cover every possible scenario here on the podcast without putting everyone to sleep, I do want to address three final questions. These questions cover some of the additional nuances that can sometimes get skipped over in broad-based articles and discussions.
Ok, let’s not waste any time and get right into the first question:
Knowing the benefit of tax-loss harvesting is from growing the deferred tax bill (the temporary loan), how exactly does the deferred tax bill grow if I’m deducting the maximum $3,000 loss from ordinary income instead of offsetting capital gains? In other words, where is my tax deferral in this scenario, and how exactly do I grow it if I’m not offsetting gains with losses inside of my investment account?
I realize this question is a bit confusing so let me recap a few things here to help it make more sense.
As a reminder when you harvest losses, you can either offset current year capital gains or deduct up to $3,000 of your losses against ordinary income each year. Any unused losses can then be saved and carried over into future years. So, if you have a large amount of realized losses and don’t have capital gains to offset them with, you might end up slowly deducting $3,000 from ordinary income each year until those losses are zeroed out and used up.
Now, when we sell something at a loss to offset something that had a gain, the deferred tax bill (the temporary loan) is usually baked into the full cycle of the loss harvesting transaction, and it, more or less, remains invested inside of our investment account.
Said another way, if harvesting some losses prevents you from having to take money out of your portfolio to pay a capital gains tax bill, your deferred taxes (i.e., your temporary loan from the government) remains invested inside your investment account.
But if you don’t have any capital gains and you have realized losses to simply offset ordinary income up to the $3,000 maximum limit, we have to take some extra steps in order to identify our deferred tax bill and attempt to grow it. Otherwise, we aren’t really benefitting from tax loss harvesting.
Let's run through a simple example to help make better sense of this.
Let’s say I’m in the 24% tax bracket and I want to harvest $3,000 of investment losses so I can deduct it from my ordinary income this year – my income earned from working.
I have a $20,000 investment that I made in an iShares emerging market ETF and, over the past year, it has lost value and is now worth $17,000. So I sell it, harvest the $3,000 loss, and immediately buy $17,000 of a Vanguard emerging market fund to replace it in my portfolio and avoid triggering the wash sale rule.
To calculate how much this little tax loss harvesting transaction is saving me in taxes this year, we can simply multiply my current ordinary income tax rate of 24% by $3,000 (the amount I’m deducting from my income).
$3,000 times 24% is $720, so by deducting the $3,000 of emerging market fund losses from my ordinary income, I recognized a tax savings of $720.
Most people often stop there and celebrate the fact that they just saved $720 in taxes this year. But we can’t forget what happened with my iShares emerging market fund transaction that allowed me to capture these tax savings.
I originally bought $20,000 of the iShares emerging markets fund, the value dropped to $17,000, I sold it all, harvested the $3,000 loss, and bought a Vanguard emerging market fund with the $17,000 in proceeds.
This means that the cost basis on my new vanguard fund is $17,000 – it’s $3,000 less than my original/starting cost basis of $20,000. What this means is that when this new $17,000 investment grows to $20,000 in the future, I’m going to have a capital gains tax bill to pay on it. A tax bill that I would not have otherwise had if I didn’t do any tax loss harvesting to begin with.
To bring this full circle, let’s fast forward and say I’m in the 15% long-term capital gains tax bracket (remember, capital gains are taxed on a different schedule–let’s say I’m in the 15% long-term capital gains bracket when that $17,000 finally grows back to the original $20,000 again. I need the money so I go ahead and sell it all and realize the $3,000 in capital gains and now I have a $450 tax bill to pay.
So, to summarize this whole transaction, I captured an immediate tax savings of $720 by selling my ishares fund at a $3,000 loss and using it to offset ordinary income this year. But in doing so, I also created a future capital gains tax bill of $450 when my $17,000 investment grows by the same amount in the future. That $450 tax bill would not exist if I didn’t harvest any losses to begin with.
Now think about what happens here when I go to file my tax return. I file my taxes and I’m excited because I just saved $720 in taxes by offsetting some ordinary income. But where does that $720 in savings go? Well, it either reduces the amount I owe the IRS that year or it comes back to me in the form of a refund.
In either case, that $720 often disappears into my day-to-day cash flow. It either reduces the size of the check I write to the IRS or the refund is deposited into my checking account and fail to think about this future $450 capital gains tax bill I’ve created through this whole tax loss harvesting exercise.
So, if I spend my $720 in tax savings, I’ll have to find another way to pay for that $450 tax bill in the future. In addition, I’ve also just erased any potential benefit to doing tax loss harvesting because, as you know, the actual benefit is in the tax deferral—and growing that tax deferred amount by investing it. If I spend the tax savings, there’s no tax deferral (or temporary loan from the government) to defer and grow. It’s been spent.
Ben Henry-Moreland, a researcher for Kitces.com, uses the analogy of a stock paying you a dividend. As we all know, dividends should be automatically reinvested so you can take advantage of the magical benefit of compounding growth over a long time horizon. If you instead spend the dividends you receive, your performance will be significantly reduced.
Coming back to tax loss harvesting, deducting $3,000 of losses against ordinary income essentially creates a dividend. In my example, that dividend was $720. But unlike stocks and ETFs and mutual funds, there’s no way for me to automatically reinvest that $720 dividend I just received. For that reason, it’s easy for it to just kind of disappear into my cash flow after my tax return is filed.
Using this example, when there are no capital gains to offset and we are offsetting income instead, we need to manually take our current year tax savings (that $720) and invest and grow it. Let’s say we grow that $720 to $1,500 over the next 7 years. Well, now when we have that future capital gains tax bill of $450, not only do we have enough to pay that tax bill, but we have an extra $1,000 (and change) in our pocket.
We deferred taxes through tax loss harvesting, invested the tax savings, and we were able to benefit from this tax strategy. But it took some extra steps in order to make that happen, which for investors, may or may not be worth the effort.
Before we move on to the next question, one idea to make reinvesting your tax savings easier is to estimate and automate. In other words, if you plan to deduct $3,000 of losses every year and your income is relatively predictable, you can calculate what the projected tax savings are and just send that amount automatically into your investment account each year.
For example, if it’s projected to be $720 in tax savings, maybe divide that by 12 and contribute an extra $60/month to your investments. Increasing your monthly contributions by that amount automatically will help you capture the benefit of tax loss harvesting and avoid spending your tax savings every year without you even knowing it.
Question #2 - What if I have been investing small sums of money into the same investment for a long period of time? In other words, instead of investing $500,000 all at once into the Vanguard Total Stock Market Fund, what if I’ve been investing $50,000 at a time for the last 10 years? How might I be able to navigate tax loss harvesting in this situation and are there any mistakes to be aware of?
So, in all of my examples throughout this series, I’ve used individual investment purchases and sales to illustrate specific concepts. I did this to keep things simple, but it doesn’t always reflect what often happens in real life. As this question highlighted, many of us are investing in a basket of different securities on a regular basis and over a long period of time.
In other words, we don’t necessarily always make one single lump sum investment and then monitor its performance for tax loss harvesting opportunities. We make dozens, if not hundreds, of small investments into one or more securities at all different times, and those small investments kind of get lost in the overall time-weighted return of our total portfolio. This can make it much more difficult to maximize the benefits of tax loss harvesting if we’re not careful. Here’s why.
Let’s continue with the example used in the question and say that I made 10 different $50,000 purchases over the last 10 years into the Vanguard Total Stock Market Fund. So, in total, I invested $500,000 of my money, but at all different times.
Well, the Vanguard Total Stock Market fund has done pretty well over the last 10 years, so on my monthly statement, on paper, it might tell me that my investment has made money. And that’s because most of my $50,000 purchases were made in a bull market and had positive growth.
However, my last $50,000 investment – the final 10th purchase – was made exactly 12 months ago. And over the last 12 months, the Vangaurd total Stock Market fund has not done very well. In fact, it’s down about 16% which means my last $50,000 purchase has lost $8,000.
There are two problems to keep an eye out for here.
The first is that some investors might not realize they have a tax loss harvesting opportunity here. Their monthly brokerage statement shows that their total investment in their Vanguard Total Stock Market has increased in value over time which might cause them to quickly conclude that there are no losses to harvest.
In this example, we have taken note that we actually have 10 different tax lots, and whether we realize it or not, each of those 10 lots has performed differently. Most increased in value and have gains but some have not.
The second is that even if we realize that we have 10 different tax lots, each with their own capital gain or loss, we overlook something called tax lot accounting and which method their brokerage firm is going to use when some of a security is sold. Most brokerage firms default to using FIFO, or First-In First-Out.
So if I have those 10 - $50,000 tax lots invested in the Vanguard total stock market fund, and I go to sell $100,000 of it because I need some extra cash, it’s very possible that my custodian is going to sell my first two tax lots. The first $50,000 I invested 10 years ago and the second nine years ago. And, because the market goes up more than it goes down, those two tax lots will likely have the largest capital gains.
Now, in some cases, we do want to use FIFO, because using LIFO (last in first out) could trigger the more expensive short-term capital gains on a more recent investment (or tax lot) that has been held for less than a year. So, there’s not necessarily a bad tax lot accounting method, we just need to be aware of what method is being used, because we do have the ability to tell the custodian to use a different one each time we sell securities.
So, to recap the two problems, we need to first understand that even if our monthly statement is showing that an investment we have has gone up in value over time, we might actually have individual tax lots within that investment that have losses we can harvest. And two, we need to be aware of what accounting method is being used when selling shares of a stock, ETF, or mutual fund.
Going back to our original example where I made 10 $50,000 purchases of the Vanguard Total Stock Market Fund, I can actually log into my investment account online, click into the cost basis information for that fund, and review the gain/loss of each tax lot. When I see that my last $50,000 purchase 12 months ago has an unrealized loss of $8,000, I can consider realizing and harvesting that loss by selling that specific tax lot. I just have to indicate that to my custodian or brokerage firm when I go to sell so they don’t use the wrong accounting method.
And, as noted a couple of minutes ago, this situation can arise even if tax loss harvesting is not something you are attempting to pursue. For example, it could just be that you need to sell some shares of a fund and you want to do it in the most tax-efficient way. Knowing that there are different accounting methods and knowing that you can indicate which one is preferred, will help you accomplish your goal of withdrawing funds tax efficiently.
And this leads nicely into our third question which is: What about Direct Indexing? What is this and why is tax loss harvesting brought up as one of the benefits?
This is a long topic and deserves its own episode, but in short, direct indexing allows you to essentially build and manage your own index fund with individual securities.
A simple example is, instead of investing in an S&P 500 index fund, you could use a direct indexing platform to buy all 500 individual securities in your portfolio and match the exact weighting of the S&P 500.
Think about our last example where we talked about 10 different $50,000 tax lots of the Vanguard fund. Well, in this situation, we could have 10 different $50,000 tax lots in 500 different securities that exactly match the S&P 500. Your money is invested in a portfolio that mirrors the S&P 500, but you are able to tax efficiently manage each of the 500 positions at the security level instead of the fund level. Each $50,000 investment you made is spread out over 500 different purchases instead of one fund purchase.
This approach is absolutely a way to maximize the tax loss harvesting benefits and studies are already rolling out suggesting that direct indexing can boost after-tax returns by over 1% per year. But, as you might already be catching onto, the cost of using a direct indexing service eat into some or even all of the benefit being created. It isn’t exactly cheap to provide a service that creates and manages custom indexes made up of individual securities for each individual person and then navigates all of the tax lots to maximize the benefits of tax loss harvesting.
Even if costs do appear to be reasonable, we have to keep in mind how cheap investing has become. You can invest in an S&P 500 fund at basically no cost. And you can invest in most other broad asset classes for a few basis points. So anything you pay a direct indexing service for is more than what it would cost to buy a few simple index funds.
The benefit of that service needs to prove that it outweighs the cost. And that’s tough because there is a second headwind, which is the performance of the individual securities and the tracking error experienced during the wash sale period.
Lastly, in many cases, drifting from an index is intentional. For example, if you want to invest in the S&P 500 but there are 20 companies that you just don’t want your money invested in because you don’t agree with how they do business, you can create a custom index that mirrors the S&P 500, but eliminates those 20 companies. So now you own 480 individual securities instead of 500 and you have made an “active” investing decision instead of a passive one. Most of us know that actively managed portfolios, over long periods of time, underperform passive ones.
So, if the extra fees don’t eat into the benefits of direct indexing, over a long enough time horizon, the active decisions many investors are unknowingly making will likely take care of that.
I’m not totally pessimistic about direct indexing, but kind of like tax-loss harvesting, I don’t think it’s the free lunch no-brainer that some make it out to be. I think it creates more complexity than most need and complexity that, if not navigated perfectly, could do more harm than good. Again, direct indexing deserves a longer conversation here on the show in order to fully understand all of the opportunities and drawbacks, but in the meantime, if you want to learn more I’ll link to a few good articles in today's show notes.
Ok, let me bring us home here with a couple of things to think about as we digest everything we learned in this series.
Just like roth conversions (and many other tax planning strategies), one of the most important exercises to go through when deciding if tax loss harvesting makes sense for you is to identify your current tax rate and compare it to your future projected tax rate. Tax planning can make a giant dent in the amount you will pay the IRS between now and the end of life. And that dent is not a result of doing anything illegal or magical or something super top secret for the ultra-wealthy—it’s a result of being proactive and paying taxes at the most favorable tax rate possible.
This means that proactive tax planning, when done correctly, requires a thoughtful analysis at least one time per year, and in many cases, multiple times per year. And it highlights why just working with a CPA likely isn’t enough. Many CPAs are just focused on one side of the equation, which is what is happening right now in the current tax year. But, pulling a tax lever today, in the current year, can cause positive or negative changes in future years. And we need to know what those changes are so we can make informed decisions. We don’t benefit from doing tax planning in a vacuum and looking at each year in isolation.
Like many other decisions in life—going to college, staying at a job you hate, sending a thoughtful thank you card—the decisions we make today will have a direct impact on where we find ourselves in the future. By thinking long-term, being proactive, and making informed and educated decisions every day or every year, we can put ourselves in the best possible position for success. Professional success, personal success, or, financial success.
To grab the show notes for today's episode, which includes links to articles referenced today, head over to youstaywealthy.com/167.
Thank you as always for listening, and I will see you back here next week.
Episode Disclaimer:This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.