My investment strategy is dead stupid. I tend to purchase low cost index funds, automatically and at regular intervals, and hold them indefinitely. My ten-month-old daughter could administer my investments, provided I could wire the big cow button on her activity center to Vanguard’s web servers. I don’t understand complex investment maneuvers, and I certainly don’t have any advanced knowledge of the stock market based on some news I read about Brazil. I wear my ignorance with a modicum of pride, because I believe that the average investor benefits from doing less rather than more.
So when I say that I Tax Loss Harvest, I don’t want to chase away my fellow investus ignoramus. “Okay, he’s talking about advanced moves,” they may wrongly think. “This doesn’t apply to me. I’ll move along.” This would be a huge mistake, because though Tax Loss Harvesting sounds complex, is it a simple process that any investor can take advantage of. And when done correctly, it can guarantee a years-long stream of money in the form of lower taxes. In this post, I’ll explain the process and its benefits; then, in another post, I’ll get into the details of how to sell investments in a way that will maximize losses.
When you sell an investment that you’ve bought in the past, you either make or lose money. If you lose money, the government allows you to deduct those losses from your federal taxes, up to $3,000 per year. This will put somewhere between $500-$1000 back into your pocket (depending on your tax bracket) in the form of a tax refund or a lower tax bill.
Once an investor’s portfolio reaches $50,000 or so, it becomes easy to capture $3,000 in losses during bad stock market years. But what about years like 2013, when it was difficult to lose money? Fortunately, the IRS allows losses in excess of $3,000 to be carried over indefinitely. This means that if you had captured $21,000 in losses during the epic market crash of 2008 (not hard), you would have had enough losses to deduct a full $3,000 for seven years. That’s seven years of guaranteed payments from Uncle Sam, locked in through one stock transaction.
“But I’ve just lost thousands of dollars!” you yell angrily. “And I sold at the bottom of the market! Isn’t this tax advantage cold comfort?” This is a common concern, and one that tripped me up for some time. But here’s the secret: you’re not taking your losses and going home. Instead, you are selling and then quickly buying another investment that fits within your portfolio. In doing this, you are keeping your money in the stock market, and are taking advantage of
volatility (read: ups and downs), which history has shown to be inherent in the stock market. This is why we call it capturing losses, as if you’re grabbing a bird from the air, plucking off a feather, and returning it to flight.
There are some caveats that I should mention. First, this only works for taxable accounts. Sales on your retirement accounts such as 401(k)’s and IRA’s do not generate taxable events, and their losses cannot be harvested in this way. Also, note that it is a deduction and not a credit; it can only reduce your tax bill to $0, and will not put cash in your pocket in the same way that a tax credit can. But most importantly, it is vital that you don’t simply sell and repurchase the same or a “substantially identical” investment this could be considered a “wash sale”. This type of sale cannot be used to capture losses, and if the IRS catches this kind of behavior it may punish the investor for it.
Another common question is: “I’ve bought these funds over many years, at all kinds of different prices. How do I even know what my loss will be?” In my next post, I’ll address, in detail, how to sell shares in order to control and maximize losses.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities.