Today I’m continuing with our series on tax-loss harvesting.
Here in part two, you’ll walk away learning the following:
- Who should consider tax-loss harvesting
- Who should stay away from it
- The top 3 things that can boost the benefit of this strategy
I’m also presenting situations where tax loss harvesting can backfire, and do more harm than good. 😬
If you’re a retirement saver ready to learn how this tax strategy can be maximized, you’re going to love today’s episode.
How to Listen to Today’s Episode
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- Tax-Loss Harvesting (Part 1)
- TLH Boosts After-Tax Returns by 1.8%
- How TLH Increases Returns
- 2022 Capital Gains Tax Rates
- Academic Research:
Tax-Loss Harvesting (Part 2): Who Benefits the Most?
Taylor Schulte: Some investing services claim that regular tax-loss harvesting can improve after-tax returns by up to 1.8% per year.
Robo Advisor Advertisement: “We've long said that tax loss harvesting is the most compelling reason to use a robo advisor tax loss. Harvesting can lower your tax bill and boost your after tax returns with no extra effort on your part. And it's a task perfectly suited to software.”
Taylor Schulte: While it’s certainly compelling, more objective, academic research that takes the full cycle of an investment into consideration, suggests that the benefit is much less.
In fact, many researchers agree that tax-loss harvesting might only boost after-tax returns by about 0.30% or 30 basis points per year
And that 0.30% can get washed away pretty quickly by trading fees, changes in tax rates, and underperformance during the wash sale period.
So who is tax loss harvesting for? Who is really in a position to benefit? And, maybe, more importantly, who won’t benefit from this tax strategy?
And that’s what we're tackling today on the show.
Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m continuing with our series on tax loss harvesting.
Here in part 2, I’m sharing who should consider tax loss harvesting, who should stay away from it, and the top 3 things that can increase the value of tax loss harvesting.
I’m also sharing situations where tax loss harvesting can backfire and do more harm than good.
For all the links and resources mentioned today, head over to youstaywealthy.com/166.
To answer who can benefit from tax loss harvesting, let’s quickly revisit one of the problems with tax-loss harvesting–a problem that I ended last week's episode with that causes a lot of investors to pause and wonder if the juice is really worth the squeeze.
Let’s use a simple example to help illustrate.
Let’s say I buy an S&P 500 fund for $100,000. The U.S. stock market hits a few bumps in the road, and one year later my investment has dropped by 10% – it’s now worth $90,000.
I read about this thing called tax loss harvesting and decide it’s a good idea to harvest these losses. So, I sell the S&P 500 fund, harvest my $10,000 loss, and reinvest the $90,000 of proceeds into a Russell 1000 fund. Something similar but not substantially identical.
Since my current long-term capital gains tax rate is 20%, by harvesting this $10,000 loss, I just captured a current tax savings of $2,000.
However, it’s important to highlight that the cost basis of my Russell 1000 fund is now $90,000. In other words, my cost basis has been reduced from my original $100,000 investment in the S&P 500 by $10,000 – the exact amount of the loss I harvested.
And here’s why this is important to highlight.
Continuing with my example, after the wash sale period ends, I swap back into my S&P 500 fund, and a year later, the U.S. stock market rebounded and my $90,000 has increased back to $100,000. I’m happy that I’m back to even again and realize I don’t have the stomach for this kind of volatility, so I sell it and cash out.
Take note of what just happened here.
After harvesting $10,000 of losses and navigating the wash sale period, my investment rebounded by the same $10,000, I sold it and realized a $10,000 capital gain. Assuming my tax rate is still at 20%, I now have a $2,000 long-term capital gains tax bill to pay.
So put all of this together–(i.e., consider the full cycle of my investment)–and, at the end of the day, my tax savings from tax loss harvesting was a whopping $0.
That $2,000 in tax savings I captured from selling my original S&P 500 fund at a loss? It was just offset by a $2,000 tax bill on the money I made on it one year later.
This example might remind you of something I said in part one of this series last week. Which was that if there’s any benefit to doing tax loss harvesting, it’s from deferring the taxes you owe, not avoiding them.
Let’s dissect this a bit more.
In my example, where I sold my S&P 500 fund at a $10,000 loss, I was technically able to use my $2,000 in tax savings from harvesting that loss to invest it and grow it.
In Michael Kitces’ research, he refers to this as a “temporary loan” from the government, which I think is a good way to put it.
If I invest my “temporary loan” of $2,000 and it grows to $2,200 (a 10% increase), I’ve just benefited from tax loss harvesting.
But $2,000 is only a small % of my total $90,000 investment. So, if you do the math, the actual benefit in this example is only 0.22%/year or 22 basis points. Quite a bit less than the 1.8% some investment management services are suggesting.
However, there are three additional things that can really turn that extra 22 basis points into something more meaningful: 1) Compounding growth 2) Size of losses and gains 3)Tax Bracket Arbitrage
Let’s start with number one, compounding growth. All of us here in the Stay Wealthy community are smart, long-term investors. And remember, even if you’re retired, you still have 20, 30, or 40+ years to invest, which means you, too, are a long-term investor.
And I mention long-term investing because that $200 benefit (or 22 basis points) I captured from selling my S&P 500 fund at a loss, that benefit, will likely continue to grow and compound for years or even decades.
In my example, I said that I sold my investment after one year and realized the gains. And I did that to keep it simple and bring to the surface the core benefit of tax loss harvesting–the deferred taxes, or the “ temporary loan”, that you can use to invest before having to pay it back.
But again, most of us are long-term investors and we aren’t looking to turn around and sell after one year. So, in reality, it’s not just the original $200 I made by investing my “temporary loan” for one year, it’s what that $200 might turn into by year 10 or 20 and beyond. It’s the compounding growth potential.
In this example, to really calculate the long-term benefit of tax loss harvesting, we have to compare the internal rate of return of two scenarios over a long multi-decade time period. Scenario one where we harvest the losses while navigating the wash sale rule to keep our money invested and scenario two where we don’t harvest any losses and simply hold our existing investment.
Measuring a 30-year time period, the research I’ll link to shows that the excess return provided by tax loss harvesting—relative to holding onto my investment and not harvesting any losses—the excess return begins to slow down and eventually decline once my $90,000 investment crosses the original $100,000 I started with. However, as you might be thinking, the end result depends on a number of other assumptions and variables, including the underlying investments we’re dealing with and their future performance.
This leads to the second thing that can improve the benefits of tax loss harvesting—the size of losses and gains. In short, the long-term benefit of tax loss harvesting is typically greater if we can immediately harvest sizeable losses from a poor-performing investment.
For example, immediately harvesting losses after a sharp 30% decline is more beneficial than immediately harvesting after a 10% or 20% decline. A larger decline harvested immediately gives us a larger “temporary loan” that we can use to grow and invest and compound over multiple years or decades. And the higher those future returns, the more of a benefit there is to tax loss harvesting. Said another way, small investment declines and low future returns will eat into the value of tax loss harvesting when measured over a long period of time.
Lastly, similar to the size of losses and gains, the higher our tax bracket, the more we can benefit. This leads us to the third thing that can boost the benefits of tax loss harvesting – and that is tax bracket arbitrage.
You see, it’s one thing to crunch hypothetical numbers and assume our tax rates will stay the same over a 30-year time period. In fact, it makes the math a bit easier when we do that.
But that doesn’t typically align with reality – changes to our income each year (or changes in the tax code) can change our tax rate. And when our tax rates change between the date we harvest losses and the date we ultimately realize gains and pay back our temporary loan, we create something called tax bracket arbitrage.
For example, if my long-term capital gains tax rate was 20% when I sold and harvested my S&P 500 fund losses, and then I find myself in the 15% bracket 10 years from now when I finally sell and realize my future capital gains, I will have benefitted from tax bracket arbitrage.
And tax rate arbitrage is typically more beneficial than the tax deferral benefits of tax loss harvesting we spoke about earlier. It typically moves the needle more than investing and growing that temporary loan…especially if we happen to be in the highest tax bracket and have an opportunity to use harvested short-term losses to offset very expensive short-term gains–gains that are taxed at ordinary income tax rates.
But there’s another group that can benefit from tax bracket arbitrage even more than the highest earners. And those are people who plan to hold their investment until death and/or donate it to charity at some point in the future.
In both scenarios, the investor is essentially guaranteeing that the future tax rate on any increased gains from tax-loss harvesting will be 0%. The cost basis will either be stepped at death for their heirs to liquidate or the non-profit receiving it will be able to sell the security without tax consequences due to their 501c3 status.
The investor won’t necessarily benefit from this multi-year or multi-decade tax-loss harvesting strategy, but the benefits of it, and the benefits of tax bracket arbitrage, will certainly be maximized for legacy planning purposes.
To recap where we’re at so far, tax-loss harvesting can potentially improve after-tax returns by up to 0.30% per year. But that benefit can be improved even further by three things: 1) Compounding growth 2) Size of losses and gains 3) Tax Bracket Arbitrage
In other words, those who can likely benefit the most from tax-loss harvesting are high earners, with a long-time horizon, who get an opportunity to immediately harvest a large capital loss, and then experience sizeable future gains. And, to top it off, realize those gains during a time when they are in a lower tax bracket.
As you might be thinking, many of those variables are either unknown or outside of our control. So, it’s not always easy to predict today if the benefits of daily or frequent tax-loss harvesting will be worth it in the future.
For example, tax bracket arbitrage sounds great when it works in your favor. But it can easily go the other way, too.
Let’s say my current income puts me at the 15% long-term capital gains tax rate. I read a random article that gets me excited about tax-loss harvesting, decide it’s a no-brainer, and go on to harvest $25,000 of losses every year for the next 5 years.
What I’ve actually done is reduced my cost basis by the same amount each year. I.e., in total, my cost basis has been reduced by $25,000 each year, or $125,000 over those 5 years. And now, when I ultimately go to sell my investments in the future, my capital gains could be so large that it pushes me into a higher tax bracket and I find myself paying 20% (or more) on these giant capital gains.
To summarize, I harvested losses at the 15% rate and then paid 20% on my future realized gains, which could very likely erode all of the value derived from tax loss harvesting to begin with.
Or how about this scenario? Let’s say I’m currently eligible to pay 0% long-term capital gains this year. And I see a clever advertisement from a robo advisor about the benefits of daily tax loss harvesting, so I move all of my investment accounts over to them. Harvesting losses for me while I’m eligible for 0% long-term capital gains is the worst possible form of tax bracket arbitrage. I should be harvesting gains, not losses.
So, tax bracket arbitrage can help and hurt us. And in some situations—like a change in the tax code—our future tax rate is both unknown and out of our control.
Other things outside of our control can eat into the benefits of tax-loss harvesting as well. For example, how our investments perform during the wash sale period will directly impact the value of this strategy. If I harvest losses on my S&P 500 fund, invest the proceeds into the Russell 1000 during the 30-day wash sale period, and then go to repurchase the S&P 500 on day thiry one only to find that it outperformed the Russell index during that timer, some or all of the value I captured from harvesting could be destroyed. I would have been better off just keeping my S&P 500 fund and doing nothing.
As you can imagine, the underperformance (or tracking error) can widen when dealing with narrower asset classes or even individual stocks. For example, if you swap Tesla stock for Ford stock during the wash sale period, and Elon Musk says something on Twitter that sends Tesla skyrocketing while you’re on the sidelines holding Ford, you can likely wave goodbye to any benefit derived from harvesting whatever losses you harvested on Tesla stock.
Another example of something unknown that can eat into the benefit of tax loss harvesting is a large, unanticipated expense that forces me to realize capital gains earlier than I had planned. In many cases, this could easily wipe out the benefits I attempted to capture during my loss harvesting years. Nothing to do with market performance or transaction fees, just purely a life event that can happen to any of us.
Like all tax planning strategies, tax loss harvesting requires a very careful analysis. Putting it on auto pilot or blindly assuming that it’s risk-free and a no-brainer can, in many cases, do more harm than good.
To wrap up this series, next week in part three, I’m going to answer some frequently asked questions about tax loss harvesting. For example, in all of my examples so far, I’m only talking about one investment, but what if someone has a diversified portfolio with dozens or even hundreds of holdings. How does that change things? Or what if someone has multiple tax lots within the same investment? What if there are no future gains or carried-over losses can’t be used? I’ll be tackling these questions and a few more.
In the meantime, you can grab the show notes for today's episode by going to youstaywealthy.com/166.
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.