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Year-end is a popular time for tax planning strategies, Roth conversions, charitable gifts, squeezing in those final tax-deductible retirement account contributions, and of course, the crowd favorite, good old tax loss harvesting.
Forbes writes that besides reducing your taxes, tax loss harvesting also frees up cash so you can buy new assets that may be more likely to generate positive performance. Vanguard states that tax loss harvesting helps you save on taxes, grow your portfolio, reduce cost, reduce risk, and turn volatility into an opportunity.
And one robo-advisor in particular claims that regular tax loss harvesting can improve your after-tax returns by up to 1.8% per year. Look, I'm all for pursuing strategies to help lower our taxes and ensure that we don't overpay the IRS.
But far too often, popular tax planning strategies are mistakenly evaluated each year in a vacuum. In other words, we identify something that helps us save a quick buck on taxes this year, but we neglect to understand what it might do to our tax bill in the future.
In the moment, tax loss harvesting feels like a no-brainer. You know, if you sold an investment earlier in the year that went up in value and triggered a capital gains tax bill, it sounds pretty enticing to be able to sell something else at a loss before the calendar turns to offset those taxes.
And while tax loss harvesting certainly has potential benefits and use cases, when you zoom out and evaluate the impact of this tax strategy over a longer period of time, those benefits can get washed away pretty quickly. Even worse, the short-term benefits can sometimes turn into long-term drawbacks.
So before you or your advisor race to your brokerage accounts this December to start your year end tradition of harvesting losses, I just want to revisit an important episode that I published on this topic about 18 months ago. I'm generally not a fan of replaying past episodes as I like to keep things fresh around here, but with three weeks left in the year, this topic is too fitting, too important and too widely misunderstood to gloss over it.
The following episode is part of a three-part series that I did on tax loss harvesting. And this one in particular specifically addresses the often misunderstood benefits and who's best suited for pursuing this strategy. If you want to learn more and dive deeper on this topic, I'll link to the other two episodes in the series, as well as some additional resources in the show notes for today, which you can grab by going to youstaywealthy.com forward slash 206.
Some investing services claim that regular tax loss harvesting can improve after-tax returns by up to 1.8% per year. 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.
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 0.3% or 30 basis points per year.
And that 30 basis points 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? That's what we're tackling today on the show. So
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 two, I'm sharing who should consider tax loss harvesting, who should stay away from it, and the top three things that can increase the value of this tax strategy. I'm also sharing situations where tax loss harvesting can backfire and do more harm than good.
To grab the links and resources mentioned today, just head over to youstaywealthy.com forward slash 166.
To answer who can benefit from tax loss harvesting, let's just quickly revisit one of the problems with this strategy, a problem that I referenced in last week's episode that causes a lot of investors to pause and wonder if the juice is really worth the squeeze here. And to do this, let's use a simple example to help illustrate, because as you've likely figured out, these things get complicated pretty quickly here. So let's start with the problem of tax loss harvesting.
Let's just say I buy an S&P 500 fund for $100,000. I take $100,000 and I invest it into a plain vanilla S&P 500 mutual fund.
The US 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. Since my current long-term capital gains tax rate is 20%, by harvesting this $10,000 loss, I just essentially captured a current tax savings of $2,000.
However, it's important to highlight here 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 by $10,000, the exact amount of the loss that I just harvested.
And here's why this is important to highlight. If we continue with my example here, after the wash sale period ends, I swap back into my S&P 500 fund. And one year later, the US stock market has rebounded and my $90,000 has increased back to $100,000. I'm happy that I'm back to even again. And I now realize that I don't really have the stomach for this investing thing. So I sell it and I 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 I realized a $10,000 capital gain. Assuming my tax rates unchanged and I'm still at that 20% rate, I now have a $2,000 long-term capital gains tax bill to pay. So,
So put all 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 $0.00.
That $2,000 in tax savings I captured from selling my original S&P 500 fund at a loss? Well, it was just offset by a $2,000 tax bill on the money I made on it one year later. And this example might remind you of something that I said last week as well, which was that if there's any benefit to doing tax loss harvesting, it's from deferring the taxes that you owe, not avoiding them. Uh,
Let's dissect this a little bit more here. So 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 Kitsis' 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 that loan, that $2,000 grows to $2,200, a 10% increase, well, I've just benefited from tax loss harvesting.
But $2,000 is only a small percentage of my total $90,000 investment. So if you do the math, the actual benefit in this example is only 0.22% per year or 22 basis points, quite a bit less than the 1.8% that some services are suggesting.
However, there are three additional things that can really turn that extra 22 basis points into something more meaningful. Uh, one compounding growth to the size of losses and gains, and then three tax bracket arbitrage. And we're going to run through all three of these. So let's start with number one, compounding growth. Uh,
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, 40 plus years to invest. So that means that you too are a long-term investor. And I mentioned long-term investing because that $200 benefit or 22 basis points that I captured from selling my S and P 500 fund at a loss, that benefit will likely continue to grow and compound for years or even decades. And so I'm going to talk about that a little bit more in this video.
In my example, I said that I sold my investment after one year and I 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 you have 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 that I made by investing my temporary loan for that 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 time period. Scenario one, where we harvest the losses and navigate the wash sale rule to keep our money invested. And scenario two, where we don't do anything. We don't harvest any losses and we simply hold on to our existing investment.
Measuring a 30-year time period, the research that I'll link to in the show notes shows that the excess return provided by tax loss harvesting relative to doing nothing and just holding on to my existing investment, the excess return begins to slow down and eventually decline once my $90,000 investment crosses the original $100,000 that 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 that we're dealing with and their future performance.
This leads to the second thing that can improve the benefits of tax loss harvesting, which is the size of losses and size of gains. So in short, the long-term benefit of tax loss harvesting is typically greater if we can immediately harvest sizable 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 a 20% decline.
A larger decline harvested immediately gives us a larger temporary loan that we can then use to grow and invest and compound over multiple years or even multiple decades.
And the higher those future returns are, the more of a benefit there is to tax loss harvesting. If I said this another way, small investment declines and lower 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 the size of gains, the higher our tax bracket is, the more we can benefit, which leads us to the third thing that can boost the benefits of tax loss harvesting. And that is this thing called 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's
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 that 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 and P 500 fund losses, and then I find myself in the 15% bracket in the future, I don't know, five, 10 years from now, when I finally go to sell and realize my future capital gains, I've just benefited from tax bracket arbitrage. I was in the 20% bracket when I, when I harvested losses, and now I'm in the 15% bracket when I go to realize gains. And
And tax rate arbitrage or tax bracket arbitrage is typically more beneficial than the tax deferral benefits that we spoke about earlier. It typically moves the needle more than investing and growing that sometimes small temporary loan, especially if we happen to be in the highest tax bracket and we 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 so than the highest earners. And those are people that plan to hold their investment until death or donate it to charity at some point in the future. In both of these 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 up at death for their heirs to liquidate, or the nonprofit 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 0.3% per year or 30 basis points. But that benefit can be improved even further by three things, compounding growth, the size of losses and size of gains, and then finally 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 sizable future gains. And to top it off, get to realize those gains during a time when they're 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 for us in our favor, but
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. I decide it's a no-brainer and I go on to harvest $25,000 of losses every year for the next five years.
Well, what I've actually done is I've 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 in total over those five years.
And now when I ultimately go to sell my investments in the future, my capital gains will be so large that they push me into a higher tax bracket. And I find myself paying 20% or more on these giant capital gains. So to summarize, I harvested losses at the 15% rate, and then I got stuck paying 20% on my future realized gains, which could have very well eroded 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 an online investing service 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 those gains, not harvesting 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.
Thank you so much for joining us.
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 31, only to find out that it outperformed the Russell index during that time, some or even all of the value I captured from harvesting could be destroyed. And I didn't even factor in trading costs. I might've just been better off keeping my S&P 500 fund and doing nothing at all.
As you can imagine, the underperformance or tracking error can widen when we're dealing with narrower asset classes or even individual stocks. For example, if you swap Tesla stock for Ford during the wash sale period, and then Elon Musk says something on Twitter that sends the stock skyrocketing while you're stuck on the sidelines with Ford, well, you can likely wave goodbye to any benefit derived from harvesting whatever losses you harvested on that 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 that I attempted to capture during my loss harvesting years and nothing to do with market performance or transaction fees, just purely a life event that can happen to any one of us.
Like all tax planning strategies, tax loss harvesting requires a very careful analysis. Putting it on autopilot or blindly assuming that it's risk-free or a no-brainer can in many cases do more harm than good.
To wrap up the 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 different holdings? How does that change things? Or what if someone has multiple tax slots within the same investment? What if there are no future gains or carried over losses that can be used? I'll
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 forward slash 166. Thank you as always for listening, and I will see you back here next week.
