Tax-Loss Harvesting (Part 1): The 5 Things You Need to Know
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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. Here in part one, I'm breaking down what tax loss harvesting is and how it works, how to avoid getting in tax trouble, and finally, five little known things to know about wash sale rules. So if you're a retirement saver ready to learn everything that you need to know about tax loss harvesting, you're going to love this episode and this series. Today, I'm going to talk about how to get rid of tax loss harvesting.

For the links and resources mentioned today, head over to ustaywealthy.com forward slash 165. 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 taken straight from their website. And these claims coupled with mountains of advertising dollars and brilliant marketing teams have really put the spotlight on tax loss harvesting here in recent years.

When you open and fund your account, says one website, our software immediately starts looking for tax loss opportunities daily. 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. And as always, before we get into the fun nerdy stuff, here in part one, I want to lay the foundation and cover some key concepts.

I also want to highlight some of the common misconceptions and address a few nuances that I think everyone should be aware of. And even if you think you know what tax loss harvesting is, I would really encourage you to stick with me as I'm confident that you'll learn something new or at the very least interesting.

So to start, let's define tax loss harvesting in plain English. In general, tax loss harvesting is a three-step process. Step number one, you sell a security, a mutual fund, ETF, or individual stock, for example. You sell a security that has lost money and intentionally realized that loss.

Step number two, you use that realized loss to offset taxes that you owe on another investment that made money. You might also use it to offset some ordinary income, which we'll talk about here shortly. Finally, step number three, this final step is optional, and that is to reinvest the proceeds of your sale into a different security or basket of securities that matches up with your target asset allocation.

So to recap, step number one, sell a security at a loss. Step number two, use the loss to offset capital gains or ordinary income. And step number three, reinvest the proceeds into a different investment. Again, that last step is optional. We'll talk about it here 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, right?

reinvesting the proceeds from that sale, while it is common, is not technically required to engage in tax loss harvesting. Okay, so to make sure everyone is following up to this point, let's run through a couple oversimplified examples of how tax loss harvesting works and what makes it a popular tax planning strategy. We'll use our friend TaxSmartTom to help here in this first example. TaxSmartTom

A couple of years ago, Tom decided to buy $100,000 worth of Apple stock in his brokerage account. The stock has done pretty well, and today it's now worth $150,000. In other words, his investment in Apple stock has increased by 50%.

And he now has a $50,000 long-term unrealized gain. Note that 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 become realized. So he has this $50,000 unrealized gain. And after listening to this show, the Stay Wealthy podcast, he is convinced that he got lucky with this speculative single stock investment and he is 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 advantage retirement account, when you make money on an investment and then sell some or all of that investment, you have to pay taxes on the gain. So if Tom went ahead and just sold all $150,000 of his Apple stock today, well, 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 about $10,000 in taxes to sell his Apple stock. But Tom is tax smart. His name is Tax Smart Tom, 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 savers, maybe like you, Tom doesn't just own this one stock. He doesn't just own Apple 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. And as we all know, international stocks have had some trouble lately. And that international ETF that 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. So 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 then go ahead and diversify those 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 his 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 just sitting in cash from the sale of his international stock ETF. He certainly doesn't want that 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 that 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 ETF, 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 just go buy another international stock fund that more or less looks very similar to the one that he just sold. So Tom has two options here.

Option one, Tom can just 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 that even missing just a few days of good returns could take years to recoup. So he doesn't really just want his cash sitting there and doing nothing, which leads him to option number two.

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

But things get a bit murkier when you're dealing with a pooled investment like an ETF, an exchange traded fund or a 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 two mutual funds to be substantially identical? Percentage of security overlap, performance, correlation, name of the fund. The IRS hasn't provided really any additional guidance here, but most experts have come to the conclusion that for now, there is maybe more flexibility here than there should be when it comes to ETFs and mutual funds.

Let's use Tom's situation here to illustrate. Let's say that the international stock ETF that Tom sold was the iShares Core MSCI IFA ETF. The ticker symbol for this specific fund is IEFA if you just want to look it up for fun. This index fund specifically tracks the MSCI IFA index. That's an international developed index fund.

Tom, if he and or his trusted advisors agree on a more, let's say, liberal interpretation of the wash sale rule, Tom 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 that he's looking for. For example, let's say he chooses Vanguard's International ETF. The ticker symbol for this one is VEA.

Tom and his trusted advisors might determine that VEA would not trigger the wash sale rules because it technically tracks a different index. It tracks the FTSE, the FTSE developed international index instead of 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 these two funds are still substantially identical, given that they're 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 here, but still wanted to maintain exposure to international stocks and not sit in cash, he could consider maybe buying an actively managed international fund that doesn't track a specific index and contains substantially different holdings.

Now, it will, of course, be more expensive to own an actively managed fund. And Tom certainly runs the risk of underperforming his desired index. But maybe these downsides outweigh the alternative of sitting in cash on the sidelines or buying a completely different asset class. 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 then 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 or her economic position. I'll say that again. The wash sale rule exists to prevent investors like you and me from using tax loss harvesting to save money on taxes without the investor, without us changing our 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 that he sold. And Tom's economic position will most certainly change. Sure, he could get lucky during those 30 days and his actively managed fund could outperform his original index fund. But on average, I think the odds would lean towards the opposite happening.

Okay. So we ran through a lot. Let's summarize Tom's successful execution of tax loss harvesting before moving on. Tom was able to sell all of his $150,000 of 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 more or less 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. You see, Tom didn't really harvest any losses. He just sold a security at a loss to offset the taxes he owed on a security that had a gain. And then he navigated the wash sale rules to more or less keep his investment plan intact.

But the other way an investor can engage in tax loss harvesting, and this is probably the more common or popular way, is to proactively sell securities at a loss throughout the year, even if there aren't any capital gains that those losses can be applied to right away. These losses are, quote, harvested and they're saved for a future year. The technical term for this is tax loss carry forward.

These harvested losses can be carried forward and either be used to offset up to $3,000 of ordinary income in a given year and or offset future capital gains.

One of the biggest attractions, while it may not be as valuable as some think, but one of the biggest attractions is that these harvested losses will never expire. We'll talk more about this in a future episode in the series, but here's how this all 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 strain too far 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 ETF at a loss and then put that money in cash or buy a completely different asset class like a US stock fund just to get around the wash sale rule and harvest some losses.

That would cause them to have a higher percentage of US stocks or cash than they had intended. And I realize it's just for 30 days, but most smart investors who have a target asset allocation don't really 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 then 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 of an international index fund tracking the MSCI index at a loss and then 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 that they harvested along the way. Now,

Now, we'll talk more about the pros and cons of this in an upcoming episode and how to decide if proactive daily, monthly, yearly tax loss harvesting really makes sense for you. But for now, I just want you to take note of what's really 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 you go and realize wipe out most or even all of that benefit.

My friends at Alpha Architect summed this up pretty well by saying the following, quote, the taxes saved today will simply end up being paid in the future because proceeds from the sale or 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 and philosophy later in the series, but for now, it's just something to think about as we build on the concepts that we learned today. And speaking of those concepts, once again, everything that I shared today was intentionally overly simplified. And like most things we cover on the show, there are dozens and dozens of nuances, rules, and unique situations to be aware of. And

And don't worry, we will be getting into some of those nuances. But to round out part one of this series, I've pulled together what I think are our five little known things that everyone needs to know about tax loss harvesting and specifically the wash sale rule.

So number one, the wash sale rule, contrary to what some people think, applies to all of your investment accounts at every institution, including retirement accounts like IRAs. So for example, if you sell Vanguard's International Fund, VEA, at a loss in your Schwab brokerage account, and then you immediately buy it back in your Fidelity IRA thinking that you were clever, you're

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 even restrict trading. Number two, 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 that same security or a substantially identical one in my wife's account.

Number three, 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 think that you can immediately buy it back in January when the calendar turns to avoid the wash sale rule. The rule is not confined to the calendar year. 30 days is 30 days.

Number four, tax loss harvesting and the wash sale rule applies to all securities with a QSIP number. The example I shared today 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. So be careful and don't think you can sneak this one past the IRS.

Lastly, number five, in my examples today, we were only working with long-term gains and long-term losses. These are securities held for longer than one year. As you know, long-term gains receive better tax treatment than short-term gains, which are taxes, ordinary income, i.e. they're taxed just like the paycheck that you receive from work. If you're still working, 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. Let me say that again. 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 here. Let's say that you sold XYZ stock today and you realized a $15,000 long-term loss. Let's say that you also sold a few other securities that made money. And in doing so, you realized a $15,000 long-term gain as well as a $15,000 short-term gain.

So you've got $15,000 of long-term losses realized, and you have $30,000 of gains realized, half of which are long-term and half of which are short-term. Unfortunately, your $15,000 long-term loss must be first applied to the $15,000 of long-term gains, i.e. the same type.

which is helpful, but it still leaves you with $15,000 of higher cost short-term gains that you've now realized, which most investors would have preferred to wipe out instead. If on the other hand, you had $30,000 in long-term losses, well, the first $15,000 could have been applied to the long-term gains. And then the remaining $15,000, the excess could then be applied to the short-term gains.

Given this often overlooked piece of the rule, it's important just to pay close attention to 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 that you've realized and harvested is to use them to offset more favorable long-term gains. You would typically want to use short-term losses to offset the more expensive short-term gains instead.

Again, overly simplified. There are a ton of it depends type situations here. The takeaway is just to be aware of the type of losses and gains that you're dealing with so you can maximize the tax benefit of this strategy.

To recap these five things that everyone needs to know specifically about the wash sale rule. Number one, the wash sale rule applies to all of your investment and retirement accounts at all institutions. Number two, the wash sale rule applies to both your accounts and your spouse's. Don't try to get sneaky. Number three, the rule is not confined to the calendar year. 30 days is 30 days.

Number four, the rule applies to all securities with a QSIP, including stock options. And then number five, short and long-term losses must be first used to offset gains of the same type.

One final reminder here to avoid any confusion. Remember that the IRS only cares about losses with regards 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, well, go for it. In fact, the IRS would probably love for you to do it regularly because that means that they would collect some tax money along the way when your 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 the investor changing his or her economic position.

In case you missed it, I did do an episode on tax gain harvesting. I think it was last year or the year before. I'll link to it in the show notes if you want to check it out, but maybe finish the series first so you don't get these two things confused. Okay. With the foundation laid down for tax loss harvesting, we'll move into part two next week where I'll 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 and resources mentioned in today's episode, head over to youstaywealthy.com forward slash 165. And don't forget, if you want to subscribe to the Stay Wealthy e-newsletter, just head over to youstaywealthy.com forward slash email, or just click the link in your app down below in the episode description.

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