Instantly Increase Your Investment Returns With Tax-Loss Harvesting

Tax-Loss harvesting is a way to "harvest" losses in your portfolio by selling an asset that has declined in value and then subsequently purchasing a similar/correlated, but not "substantially identical" (i.e. an assets so similar that the IRS views it as being the same thing), asset so that your asset allocation/market exposure remains the same. That's certainly a mouthful!

So what does it all mean? 

Let's break it down into more easily digested pieces.

As you probably know, when you sell an investment that has increased in value (i.e. capital gain) you must pay taxes on the profits. Some of us may forget that the opposite is also true. When you sell an investment that has declined in value (i.e. capital loss) you are allowed to deduct the loss from your income, lowering your overall taxes.  The first step in the 2-part tax-loss harvesting process is to take advantage of this fact.

Picture this, you’ve just finished reading Part 1 and Part 2 of the GoGreenDollar post, Why Saving Your Money In The Bank Will Leave You Broke, and you’re super-energized about moving money from your bank account to an investment account.

You open a Vanguard investment account and invest $10,000 in one of their Total Stock Market index funds.

The market immediately tanks.

Over the next few weeks, the value of your $10,000 investment drops 10% and is now only worth $9,000. Being a savvy GoGreenDollar reader, you don’t panic. You know this is the perfect opportunity for tax-loss harvesting. You take the first step by selling your investment to harvest the $1,000 loss.

By selling, you've created a $1,000 tax deduction, but you've also sold a losing investment, locking in the loss.

This can't be a good thing, right? I’m pretty sure buying high and selling low is not part of the formula for achieving financial independence.

Well, if we were to stop at this point that would be absolutely correct. But remember, there are two parts to the tax-loss harvesting process…

After selling your original investment to capture the $1,000 loss, you immediately execute the second step in the tax-loss harvesting process by using the $9,000 in your account to buy into one of Vanguard's Large-Cap index funds. Since this fund tracks a different market index (total stock market vs. Large-Cap) the IRS will not consider it to be significantly identical to your original purchase. It is, however, highly correlated to your original investment.

Being “highly correlated” means that these two market indices tend to move together. When one goes up so does the other, when one goes down the other does as well. As a result, investing in one will produce very similar results to investing in the other. Look at the chart below to see how closely these two investments align.

Other Highly Correlated Funds: U.S. - VTSAX / VFIAX / VLCAX, International - VTABX / VFWAX / VTMGX, Growth - VSMAX / VIMAX / VEXAX

After a few months the market recovers (as it always does).

The value of your investment is $10,000 once again. However, since you performed tax-loss harvesting you were able to capture a $1,000 tax deduction without changing your market exposure! Not a bad deal right?

Let's walk through another example and examine the numbers.

Brian recently invested $25,000 into a total stock market index fund. In the time since he made this investment, the market has dropped 15%, bringing the value of his investment down to $21,250. Instead of holding the investment and waiting for it to recover, Brian decides to perform tax-loss harvesting.

Assumptions
Tax Rate = 25%

Step #1
Brian sell’s his total stock market index fund for $21,250, harvesting a $3,750 loss.

Step #2
Brian immediately reinvests the $21,250 into an S&P 500 index fund, maintaining his market exposure.

The market moves up and Brian finds his investment is now worth $30,000. What was his total return?

If Brian had simply held his investment he would have made a 20% return (i.e. $30,000 - $25,000 = $5,000). Not bad!

But what happens when we factor in the tax savings from tax-loss harvesting?

With a tax rate of 25%, the $3,750 loss Brian captured will allow him to reduce his taxes by $937.50 (i.e. $3,750 x 25%). Thus, the total overall return looks as follows:

Investment Growth = $30,000 - $25,000 = $5,000

Tax Savings = $3,750 x 25% = $937.50

Total Return = $5,000 + $937.50 = $5,937.50

That’s a 23.75% return (i.e. $5,937.50 / $25,000)!

By performing tax-loss harvesting Brian was able to increase his overall return by 3.75%! I don’t know about you, but I think that’s well worth a few minutes of work.

A wash sale is any sale that occurs within 30 days before or after a substantially identical asset was purchased. Any loss that occurs as a result of a wash sale is non-deductible.

Without the wash-sale rule, an investor would be able to sell an asset at a loss and then immediately repurchase the exact same asset for the same price. They would lock in the “loss” and still be able to keep the asset. The wash-sale rule was created to prevent investors from claiming these types of artificial losses. Tax-loss harvesting allows an investor to obtain similar results without violating the wash-sale rule.

The wash-sale rule is the reason why tax-loss harvesting uses assets that are highly correlated but not substantially identical.

Note: If you do accidentally create a wash sale, it won’t completely nullify your entire loss, it only cancels out the proportional of the loss equal to the number of shares that were purchased during the 60-day window (30 days before and 30 days after).

Note 2: The wash-sale rule applies across all of your investment accounts (including retirement accounts). So even if the transactions happen in totally different accounts, you can still create a wash sale.

Note 3: Even when a loss is disallowed because of a wash sale, you don’t totally lose the deduction. Instead, the amount of the deduction is added to the cost basis of the asset you repurchased. Whenever you sell the asset in the future the amount of the loss will be factored in (assuming you don’t create another wash sale).

When considering tax-loss harvesting, there are a few things you should keep in mind.

1. Tax-loss harvesting can only be performed in your taxable investment accounts. Buying and selling in a retirement account is not a taxable event, and so, Tax-Loss Harvesting provides no benefit.

2. The maximum tax deduction for a harvested capital loss is $3,000 per year. However, if you capture a loss greater than this it can be continually carried over as a deduction for future years (up to $3,000 per year) until the amount of the loss is exhausted.

3. Automatically reinvesting dividends can trigger a wash sale if dividends are paid and reinvested within 30 days before or after you have executed a tax-loss harvesting transaction. To avoid this, you may want to check the dividend payment schedule before performing tax-loss harvesting and/or manually invest dividends so that you avoid any conflicts.

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