Tax Loss Harvesting: An Introduction

Posted on: October 2, 2013 by Martin Curiel, CFA in Tax Strategy

One of the best and least-utilized ways to reduce tax liabilities is to implement a technique called Tax Loss Harvesting. At a basic level, the approach involves selling securities that have lost significant value to offset gains from other investments and/or to reduce up to $3,000 in ordinary income. In some cases, an investor can simultaneously buy an investment that is not similar by IRS standards, yet provides similar risk exposures and return profiles. In our experience, many families do not fully take advantage of this strategy; for those that do, tax loss harvesting takes place once a year (typically toward the end of December). A better strategy is to continuously implement tax loss harvesting. This article offers some hints on how to use this technique successfully.

Some say that every investor should seek to pay as much in taxes as possible. A large check to federal and/or state treasury departments implies that the investor has achieved large investment gains. We partially agree with that objective; however, we do believe that even when an investor’s gains are significant, there is plenty of opportunity to reduce the impact of taxes. Due to time constraints and/or lack of integration between tax and investment strategies, many investors leave extra money on the table come April 15. One simple technique to increase tax efficiency is tax loss harvesting.

How it works

Taxes on investment gains depend on whether the gains are considered long-term or short-term capital gains. For example, if an investor holds an investment for longer than one year, the gain on the investment is taxed at a rate of no more than 20% at the federal level. By contrast, short-term capital gains can be taxed at ordinary income rates, which in 2013 could be as high as 43.4% (if you include the Unearned Income Medicare Contribution Tax on investment income) for some high-net-worth investors. (By the way, this doesn’t include state tax, which in California can be over 10%.)

Tax loss harvesting is a simple way to “accumulate losses” that can be used in current or future years to offset investment gains, both long-term and short-term. It can be done effectively when certain investments temporarily decline in value (e.g., the U.S. stock market decline during the 2009 financial crisis or the few days following President Obama’s re-election). Even for the long-term, “buy and hold” investor, it can make sense to do some short-term trading to take advantage of temporary dislocations in the market.

The “value” of these losses can be significant. For example, assume a high-net-worth California investor had short-term gains of $100,000 in various investments such as stocks, real estate, and the sale of a business. Short-term gains are typically taxed at ordinary income rates. So if the investor’s combined marginal tax rate – state and federal – were around 50%, then his or her tax liability would be about $50,000 for the year. That hurts. However, if the investor were able to “harvest” $100,000 or more during the year, he or she would defer or even eliminate the need to pay this amount. In addition, any losses in excess of gains would be used to offset ordinary income up to $3,000. At a 50% rate, this is $1,500 in the investor’s pocket. Remaining losses could be carried over into future years to offset future gains and income. We will spare you the discussion of estimating the present value of these future benefits.

From the example above, one can see that there is tremendous value in this technique, particular for those investors who plan to realize significant gains in a given year. In today’s market environment, in which stock and bond indices are at all-time highs, this technique can become even more important.

Avoiding the Wash Sale Rule

To use the capital loss against investment gains and ordinary income, it is important that the investor not purchase a “substantially identical security” within 30 days of the sale. This is known as the “wash sale rule.” (See Internal Revenue Code section 1091 for more details … and make sure you have lots of caffeine to stay awake.) The wash sale rule can be avoided in two main ways. One way is to simply wait the 30 days required by the IRS to repurchase the same security. There is a risk, however, that the security might appreciate substantially in value during that time period.

The second – and preferred – way is for investors to buy a security that is “dissimilar” from the one sold, yet has similar risk exposures and return profiles. This can take some time and skill, but if done correctly is the most efficient way to capture capital losses.

Take, for example, a client who has an allocation to U.S. stocks via the mutual fund Vanguard’s Total Stock Market Index Fund (Symbol: VTSMX), which holds over 3,300 stocks at the time of this writing. One could conceivably sell VTSMX and simultaneously buy the Vanguard S&P 500 exchange-traded fund (Symbol: VOO) , which is invested in the largest 500 stocks in the United States. One could argue that VTSMX and VOO are not similar securities. One is a mutual fund and one is an ETF; one invests in all U.S. publicly traded stocks (or close to it) and the other invests in only the 500 U.S. publicly traded stocks that make up the S&P 500 Index. However, a closer examination of the monthly returns for VTSMX and VOO shows that the two securities have over a 90% correlation; this means that they essentially move in the same direction almost all the time. Why is this? Because the largest stocks in VTSMX carry disproportional weight inside this capitalization-weighted fund, and thus drive most of the return. It is often not intuitive, but the smallest 2,500 stocks in VTSMX are generally insignificant to the final return value of the fund. In short, an investor that swaps VTSMX for VOO should acheive a similar return over time. Given that the two securities are different the trade should not trigger the wash sale rule.

The approach of finding dissimilar vehicles that produce similar returns and risk exposures can be applied countless ways across the universe of stocks, bonds, and other publicly traded securities. The key is to understand the correlations among various asset classes and markets – something that MYeCFO spends a lot of time researching.

Inefficient Strategies / Efficient Strategies

To summarize, the MYeCFO perspective and insight on this topic:

  • Not integrating tax strategy with investment strategy

  • Only harvesting losses once a year or infrequently

  • Not taking action using the pretext: “I am a long-term, buy-and-hold investor”

  • Fully considering tax implications with investment decisions

  • Continuously monitoring for opportunities to harvest tax losses (e.g., when there is a temporary dislocation in the markets)

  • Buying “dissimilar securities” that have similar risk exposures/return profiles to avoid the wash sale rule

Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.