One benefit of a market trending down is that an investor can get Uncle Sam to share in his losses. Up to $3000 a year in net investment losses can be deducted from your regular income. In a typical physician tax bracket, that’s worth about $1000 in cold hard cash. If you have more losses than $3000, the loss can be carried over and applied to your future tax bills.
For many people, it is hard to sell a losing investment. You have to admit you didn’t have the ability to tell the future. Once you admit that your crystal ball is always cloudy, you realize that the intelligent investor can take advantage of the downturn.
How to Tax-Loss Harvest
#1 Buy and Hold Investments You Want to Hold For a Long Time
If you’re not jumping around in the market, market-timing, and speculating, then you’ve bought investments that you want to hold even if they go down temporarily.
#2 Harvest Losses in a Decline
#3 Trade for Something Similar
While you get the tax benefits just for selling the losing investment, if you don’t trade it for something similar, you commit the cardinal investment sin of buying high and selling low. So the wise investor SWAPS the losing investment for one that is highly correlated with it. The net effect is that your portfolio doesn’t change substantially, yet you still get to claim the losses on your taxes.
An Example of Tax-Loss Harvesting
The Stock Purchase
On March 14th, you bought $5000 worth of Vanguard Total Stock Market Index Fund (TSM) at a price of $32.64 a share and $5000 worth of Vanguard Total International Stock Market Index Fund at a price of $15.67 a share.
On Friday, August 5th, you exchanged the TSM for Vanguard Large Cap Index Fund, selling the shares of TSM at $29.99 a share and exchanged the TISM for Vanguard FTSE Ex-US Index Fund, selling the shares of TISM at $14.66 a share.
The new funds have a correlation with the old funds of something close to 0.99, essentially identical for investment purposes, but not for tax purposes, per the IRS, as the investments are not “substantially identical.”
You have now booked a total loss of $728.22. Given a 32% federal tax bracket and a 5% state tax bracket, you’ve now saved yourself $728.22*(0.32+0.05)= $269.44 in taxes. The best part is that if the market trends down, you can do it again tomorrow. You just have to remember not to go back to TSM and TISM for at least a month, or the “wash sale” rule eliminates your tax break.
Some critics point out that you’ll end up paying later the tax you save now because you’ve lowered your tax basis on the investment. That is true, but there are several reasons why it is still a good idea.
- First, there’s a tax arbitrage here. You get to deduct taxes at your regular income tax rate, 37% in the example, but only have to pay at the capital gains tax rate later, say 15%.
- Next, there is a benefit to deferring the taxes as long as possible. Money now is worth more than money later, not only due to inflation, but also due to the time value of money.
- Last, it’s possible you’ll NEVER have to pay taxes. If you later use the shares for a charitable donation (in which case neither you nor the charity pays the tax), or if you die and leave them to heirs (in which case there is a step-up in basis to the value of the investment on the date of your death,) then you’ll never have to pay that tax.
Obviously, you can only tax loss harvest in a taxable account. Many physicians can shelter more money in tax-protected accounts than they can save, and so have no need for a taxable account.
My current employment situation [well, current as of 2011 when this post was first written – ed] allows me to put $10K into backdoor Roth IRAs, $49K into a 401K/profit-sharing plan, and another $35K into a defined contribution plan. Since I can’t, don’t want to, and don’t need to really save that much, there’s not really much point to a taxable account for me. The small one I have is shrinking from charitable contributions. But if you do have a taxable account, the next time there is a downturn in the market, see if there is some tax-loss harvesting you can do.
What do you think? Do you tax-loss harvest investment losses? Why or why not? Comment below!
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