Using Tax-Loss Harvesting to Improve Your Returns

Tax-loss harvesting is a term you’ve probably heard but don’t know what it means. It may seem obscure, but it’s a good weapon to have in your investing arsenal. So just what the f**k is tax-loss harvesting?

Dan Egan, the Director of Behavioral Finance at Betterment is joining us to talk about Tax Loss Harvesting. We discuss what it is, how it works and what sort of benefits it provides you as a long-term investor. Tax-loss harvesting is the selling of securities at a loss to offset a capital gains tax liability.

What is Tax-Loss Harvesting?

Losing money on an investment stinks but there is a way to soften the blow a little; tax-loss harvesting. TLH means you sell an investment that has lost money. By harvesting investment losses, you can offset taxes on short-term gains and income.

You replace the investment that was sold with a similar one to keep your asset allocation the same. Okay, that’s a little confusing for us lay people. Keep reading. Here’s an example of how it works.

You bought $100 worth of Apple stock. After six months, it’s only worth $70, so you sell it at a loss of $30 and buy a similar stock, like Microsoft. At tax time, you let the IRS know that you had that $30 loss, and they will reduce your taxable income by that $30.

TLH used to be something only very high worth investors could take advantage of because it’s such a labor-intensive process. It takes a lot of tax planning.  If you use a personal financial advisor or tax advisor they should offer this benefit to you.

Now computer algorithms can do it in seconds. If you invest through Betterment, this is done for you behind the scenes automatically and for free.

Benefits of Tax-loss Harvesting

TLH is a form of tax deferment. You will have to pay taxes on that $30 you lost in Apple eventually because you embedded a future gain when you bought a similar stock, Microsoft.

But you won’t sell that for a year or more so you’ll be charged the long-term gains rate, which is lower than the short-term rate.

For tax purposes, inflation works in your favor here because that $30 is worth more now than it will be in the future when you pay your tax bill. Because of inflation, paying taxes later is better than paying them sooner because it erodes the actual value of the taxes you will eventually pay.

You know how people tell you that getting money back on your taxes (thrilling as it is) is a bad thing because of that money, your money, has been loaned to the government tax-free? Well, you can use TLH to turn the tables. TLH is like getting a loan from the IRS on which you’re earning money on over time.

Realized losses on investments can offset gains and reduce ordinary taxable income by as much as $3,000 per year.

Taxes Everywhere!

You pay income tax of course, and there are various types of taxes you pay on your investments too.

Capital Gains

A capital gain is a difference between the price you paid for an asset and the higher price you sold it for. The IRS wants a cut off that profit, and they take it in the form of a capital gains tax. There are realized and unrealized capital gains. Gains are not realized until the asset is sold.

The government wants their cut, but they also want you to be a long-term investor.

If you hold an investment for less than one year, it’s considered a short-term investment, and you will pay a higher tax rate, the same rate that your income is taxed at. Selling investments in the short term are considered a job in a way, and you’ve taxed accordingly.

If you wait more than a year to sell, you will be taxed at a much lower rate, no more than 15%. That’s a substantial difference so be sure you take that into account capital loss when you’re deciding whether or not to sell.

Dividends

Dividends are investment income from owning stocks. It’s a share of a corporation’s profits that is paid to investors. You can do two things with those dividends, keep them and pay taxes on them or reinvest them by buying more shares in the company.

Qualified dividends are taxed at the lower long-term capital gains rate. Non-qualified dividends are being taxed at ordinary income tax rates.

To be considered qualified, dividends have to meet specific criteria; they have to be issued by American corporations who trade publicly on the big exchanges like NASDAQ or the Dow Jones.

Investors must adhere to specific tax laws too. They must own the dividend paying stock for no fewer than 60 days out of a 121 day period called the holding period.

Dividends that don’t meet those standards are considered nonqualified.

Depending on your marginal tax rate, qualified dividends are taxed at 0, 15, or 20%. The dividend income has to be included with your other sources of income to determine your bracket.

Currently, the tax brackets are:

10%: Single filers earning less than $9,275

15%: Single filers earning from $9,275 to $37,650

25%: Single filers earning from $37,650 to $91,150

28%: Single filers earning from $91,150 to $190,150

33%: Single filers earning from $190,150 to $413,350

35%: Single filers earning from $413,350 to $415,050

39.6%: Single filers earning more than $415,050

Those in the 10-15% bracket are taxed at 0%. If you’re in the 25-35% bracket, you will be charged 15%, and if you’re in the above 35% bracket, you’re taxed at 20%.

Non-qualified dividends can be taxed as much as 39.6%, depending on your income bracket.

Medicare Surcharge

The Medicare payroll tax is 2.9%. You pay 1.45% of your earned income which is deducted automatically from your paycheck, and your employer pays 1.45%.

For high-income individuals, there is an additional tax called the Medicare surcharge, an additional 0.9% for those earning more than $200,000 at year-end.

Before 2013, you didn’t have to pay Medicare tax on investment income from things like capital gains and dividends.

Since 2013, however, you could owe a 3.8% Medicare tax on some of or all your net investment income. The amount is based on whichever is lower, the total of your net investments or the amount over $200,000

The amount you owe is based on the lesser of your net investment income or the amount your MAGI exceeds $200,000.

Zero Capital Gains

It is possible to pay zero on long-term capital gains, though, investments held for less than a year are still taxed at your ordinary rate. If you are in the two lowest tax brackets, 10%, and 15%, you don’t have to pay capital gains on your tax bill.

We saw in the chart above that the income limits for those brackets are probably higher than you think. Even if you are in a higher bracket, you might still be able to avoid capital gains.

The amounts are based on taxable income, not the higher adjusted gross income amount.

There is a limit to this, though. Eventually, the gains can add up to enough to bump you into a higher income bracket at which point, you’ll have to start paying capital gains.

Tax Gain Harvesting

Tax gain harvesting means you strategically sell winning investments in years your capital gains tax rates are lower than you expect them to be in the future for potential tax savings.

The wash-sale rule (discussed more in depth below) doesn’t apply here. It applies to investments that are sold to generate capital (harvesting losses) and then repurchased immediately.

Wash Sale Rule

There might be a stock that you’ve lost money on but still believe it will be a sound investment over the long term, so you decide to sell it to get the TLH benefit but then buy it right back.

This is called a wash sale. The IRS prohibits investors from selling and then immediately buying “substantially identical” stocks without a waiting period. The waiting period is 30 days before TLH and 30 days after.

If you get dividends and decide to reinvest them, you could be guilty of a wash sale without realizing it. Betterment handles this by investing those dividends into a different tier than they come from so there is no conflict.

Doing Your Taxes

This all sounds great, but it also seems complicated. How can the average person figure all this out? You don’t have to.

Betterment provides a 1099 form that you file your tax return. It includes all of the relevant transactions from your account, including tax-loss harvesting.

If you have several investment accounts and your accountant wants to double check the netting to determine TLH and to check for any wash sales, they might charge so much that any gains made from TLH are lost paying him or her.

Betterment estimate that using the TLH strategy will give you an annual after-tax benefit of 1.3%. You don’t see that reflected in your account with those companies but in the form of tax savings.

When Not to TLH

TLH is not always a good strategy. If your future tax bracket will be higher than your current one, you don’t want to employ TLH. In this scenario, it would be better to tax gain harvest.

If your current capital gains rate is 0%, don’t TLH. If you plan to hold an investment for less than a year, you won’t have enough time to see any benefit.

Always Be Contributing

The more often you are contributing to your investment account, the more opportunities there are for tax-loss harvesting. Most downturns are short-term losses so if you invest more often; you can capture more of them.

Betterment and many other platforms allow you to set up auto deposits so if you aren’t contributing regularly, set up an auto-deposit each time a paycheck is deposited into your checking account.

Switch Back Strategy

To employ a switch back strategy, you harvest losses ETF A and switch to ETF B. But you prefer ETF A so after letting enough time pass to avoid a wash sale, you switch back to ETF A.

The problem is that you held ETF B for such a short period, any gains will be taxed as short-term gains. That’s the problem with a switchback strategy; it exposes you to short-term capital gains tax rates.

The Bottom Line

We want to help you have a lower tax bill and save as much as we can when it comes to paying taxes (and interest). Without tax-loss harvesting, you can have long-term losses with your investments. If you had to do your own TLH, it wouldn’t be worth the time it takes but because there are investment platforms that do it for you, be sure to seek them out.

Show Notes

Leon Russian Imperial Stout: A beer made with marshmallow, chocolate, and graham crackers.