Tax-Loss Harvesting (Part 3): Answering Three Important Questions
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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 three final questions.

Number one, what if I don't have any capital gains to offset? In this situation, how do I maximize the benefits of tax loss harvesting? Number two, how do I properly navigate multiple tax slots and avoid making a costly mistake while doing so? And then finally, number three, what is direct indexing and why is tax loss harvesting always an advertised benefit?

If this is your first time listening to this podcast, be sure to hit the pause button on today's episode and go back to part one of this series, which aired just a few weeks ago on August 24th. I'll link to it in the show notes, in addition to some other helpful articles that were referenced in today's episode, which you can find by going to youstaywealthy.com forward slash 167.

Repeat after me. If there is any benefit to doing tax loss harvesting, it's from deferring the taxes that you owe, not from avoiding them. One more time. If there is any benefit to doing tax loss harvesting, it's from deferring the taxes that you owe, not from avoiding them.

I want that to be the main takeaway of this three-part series because yes, tax loss harvesting as we've gone through can certainly be a great tax strategy. And yes, 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 every day or every month or every year. And it's not the riskless no-brainer that many claim it to be. In fact, in many cases, there's no benefit to pursuing this strategy at all.

Even worse, tax loss harvesting can sometimes have a negative effect. And while it's impossible to cover every possible scenario here on the podcast without putting all of you 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 the broader based articles and discussions that are out there.

Okay, 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 income instead of offsetting capital gains? In other words, where's 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?

Now, 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 have two choices. You can either offset current year capital gains with those losses or deduct up to $3,000 of those losses against your ordinary income each year. And then, as we all know through this series, any unused losses can then be saved and carried over into future years.

So if you have a large amount of realized losses and you don't have any 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, that temporary loan, is usually baked into the full cycle of the loss harvesting transaction. And it more or less kind of just remains invested inside of our investment account.

If I said this another way, if harvesting some losses prevents you from having to take money out of your portfolio to pay a capital gains tax bill, well, your deferred taxes, that temporary loan kind of just remains invested inside of your investment account. It makes it kind of easy.

But if you don't have capital gains and you have realized losses to offset ordinary income with up to that $3,000 limit, we have to take some extra steps in order to identify our deferred tax bill and then attempt to grow it. Otherwise, we aren't really benefiting from tax loss harvesting.

Let's run through a simple example to help make better sense of all this. Let's say that I'm in the 24% tax bracket. And this year I want to harvest $3,000 of investment losses so I can deduct it from my ordinary income, my income earned from working. So 24% tax bracket, I want to harvest $3,000 of investment losses so I can deduct it from my ordinary income this year.

I have a $20,000 investment that I made in an iShares emerging market ETF. And let's say over the past year, it's lost value and it's now worth $17,000. So I decide to sell it, harvest the $3,000 loss, and then immediately buy an equivalent fund. Immediately take that $17,000 of proceeds and buy a Vanguard emerging markets fund to replace it in my portfolio while I navigate 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 that I'm deducting from my income.

So $3,000 times 24% is $720. So by deducting the $3,000 of those emerging market fund losses from my ordinary income, I just recognized a current year tax savings of $720. Most people often stop there and they celebrate the fact that they just saved $720 in taxes this year.

But we cannot forget about what happened with my iShares Emerging Market Fund transaction that allowed me to capture this tax savings. Remember, I originally bought $20,000 of that 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 before we did anything at all. 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 all full circle here, let's fast forward and say that I'm in the 15% long-term capital gains tax bracket. Remember, capital gains are taxed on a different schedule. So let's say I'm in the 15% long-term capital gains tax bracket when that $17,000 finally grows back to my original $20,000 again.

I need the money for something. So I go ahead and sell it all and realize the $3,000 in capital gains. When I do that, I'm now going to have a $450 tax bill to pay.

So to summarize this whole transaction from start to finish, 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. But in doing so, I also created a future capital gains tax bill of $450 when my $17,000 investment, that money, the proceeds from the sale, when that grows by the same amount in the future.

That $450 tax bill would not have existed if I didn't do any tax loss harvesting 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 that I owe the IRS that year, or it comes back to me in the form of a refund. And in either case, that $720 often just disappears into my day-to-day cashflow. It either reduces the size of the check

that I have to write to the IRS or the refund is deposited into my checking account. And I failed to think about this future $450 capital gains tax bill that 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, then 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 Kitsis.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 instead you spend all the dividends you receive, well, your performance will be significantly reduced.

So coming back to tax loss harvesting here, 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 that I just received. And for that reason, it's kind of easy for it just to 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 that we grow that $720 to $1,500 over the next seven 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 strategy. But it took some extra steps in order to make that happen, which for many investors may or may not be worth all the extra effort.

Before we move on to the next question, one idea here 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 is, maybe round up and just send that amount automatically into your investment account each year.

So for example, if it's projected to be $720 in tax savings every year because you're going to deduct that $3,000 every year for a while, well, maybe divide that by 12 and contribute an extra $60 per month to your investments and do this automatically.

increasing your monthly contributions to your investment account by that amount will help you capture the benefit of tax loss harvesting and avoid spending your tax savings every single year without you even knowing it. Okay, question number two, what if I've 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? In this situation, how might I be able to navigate tax loss harvesting? And are there any mistakes to be aware of? So in all of my examples throughout the series, I've used individual investment purchases and sales to illustrate specific concepts. And I did this to keep things simple, but it doesn't always reflect what happens in real life.

As this question highlights, many of us are investing in a basket of different securities on a regular basis and over a long period of time. We don't necessarily always take one single lump sum investment and then monitor its performance every year 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 just kind of get lost in the overall time weighted return of our total portfolio.

And this can make it much more difficult to maximize the benefits of tax loss harvesting if we're not careful. And here's why. Let's continue with the example I 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 they've 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 Vanguard total stock market fund has not done so well. In fact, it's down about 16%, which means my last $50,000 purchase is down about $8,000. It's lost about $8,000.

There are two problems to keep an eye out for here. The first is that some investors might not even realize they have a tax loss harvesting opportunity to begin with. Their monthly brokerage statement shows that their total investment in their Vanguard total stock market fund has increased in value over time, which might cause them to quickly conclude there are no losses to harvest. That $500,000 now looks like $700,000 on paper.

But in this example, we have to take note that we actually have 10 different tax lots. And whether we realize it or not, each of those 10 lots have performed differently. Most have increased in value and contributed to that growth and have some gains, but some have not.

The second thing to keep an eye out for 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 our brokerage firm is using when we go to sell a security.

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

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 slots 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 more recent tax lot that's been held for less than one 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 go to sell securities.

So to recap these 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 that we might be able to harvest. And then number two, we need to be aware of what accounting method is being used when we sell shares of a stock, an ETF, or even a mutual fund.

So 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 it 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 that you're 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. You just need some extra cash and you want to liquidate some investments and get money out 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 it 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 them up with the exact weighting of the S&P 500.

Think about our last example where we talked about 10 different $50,000 tax slots of that Vanguard fund. Well, in this situation, we could have 10 different $50,000 tax slots spread out over 500 different securities that match up with the S&P 500.

Your money is invested in a portfolio that mirrors the S&P 500, but you're able to tax efficiently manage each of those 500 positions and their individual tax slots 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 single fund purchase. This

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 on to, the cost of using a direct indexing service could eat into some or even all of the benefit that's being created. It isn't exactly cheap to provide a service that creates and manages custom indexes made up of individual securities for each person and then navigate all the tax slots 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 just a few basis points.

So anything that you pay a direct indexing service 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's another 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, let's say, 20 companies that you just don't want your money invested in because you don't like how they do business. Well, you can create a custom index that mirrors the S&P 500, but eliminates those 20 companies.

So now you have your own 480 individual securities instead of 500, and you've made an active investing decision instead of a passive one. Most of us know that actively managed portfolios over long periods of time underperform the

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 that many investors are unknowingly making will likely take care of that. And I'm not a total pessimist here about direct indexing, but kind of like tax loss harvesting. I just don't think it's the free lunch, no brainer that some are making 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 much longer conversation here on the show in order to fully understand all of the opportunities and drawbacks. But in the meantime, if you do want to learn more, I'll link to a few good articles in the show notes, which can again be found by going to youstaywealthy.com forward slash 167.

Okay, let me bring us home here with a couple of things to think about as we digest everything that we learned throughout this series. Just like Roth conversions and many other tax planning strategies that we've talked about here, 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 that you pay the IRS between now and end of life.

And that dent is not a result of doing anything illegal or magical or something super top secret that's only 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 throughout the year.

And it highlights why just working with a CPA likely isn't enough because many CPAs are just focused on one side of the equation, which is what is happening right now in this 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 that we can make an informed decision today.

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 that you hate, or sending a thoughtful thank you card, the things we do, 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 month or every year, we

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 all the articles referenced today, head over to youstaywealthy.com forward slash 167. Thank you as always for listening. Thank you for sticking with me in this nerdy three-part series on tax loss harvesting. And I will see you back here next week.