Markets are down. Robo-advisors and savvy investors are tax-loss harvesting.
But me? I had no intention of doing so.
Thankfully, two Go Curry Cracker readers correctly pointed out I was wrong to not tax-loss harvest.
Yes, I absolutely am tax-loss harvesting and loving it. (Thanks!)
First – What is tax-loss harvesting? A (very) brief summary…
You own a stock/ETF/Mutual fund in a taxable account that is now worth less than you paid for it. You sell it, realizing a capital loss. In fact, you sell it solely for the purpose of realizing the loss.
With the cash from the sale, you buy a different fund*. Your asset allocation is 99.9%/exactly the same as before, but now you have a shiny new loss to show the IRS.
That’s it. Enjoy the tax deduction (yes, there is nuance that isn’t covered here…)
* any fund that follows a different index. In IRS-speak, a non-substantially identical investment.
Benefits of Tax-Loss Harvesting
With a realized loss on a tax return, we get a few main benefits.
First, income is lower. Lower income = lower taxes at all levels, Federal / State / ACA.
Second, tax deferral. Because our portfolio basis is now lower, we may owe some taxes in the future… but in the mean time we benefit from tax deferral. Those possible taxes might not be due for 10, 20… 50 years. Or ever.
Third… the conversion of a capital loss into an ordinary loss equivalent.
If losses EXCEED gains then you can use up to $3,000 per year to offset ORDINARY INCOME. (Any additional loss carries forward.)
Tax rates on capital gains are low, often 0%. If you are paying no tax on long-term capital gains, getting a deduction against them is worth zero (at least on federal taxes.)
But tax rates on ordinary income are much higher, in the range of 12-22% for most people (but as high as 37%!)
Tax loss harvesting converts that lower-value capital loss into a high-value ordinary loss equivalent. A $3,000 tax deduction for somebody in the 37% tax bracket is $1,110!
And finally… a capital loss carryover. Any amount of capital loss that cannot be deducted this year will carry forward. This can allow for many years of tax-free stock sales.
That all sounds pretty good.. so, why was I not planning to tax-loss harvest?
don’t Tax-loss harvest
I spent nearly 10 years aggressively capital gain harvesting, raising our basis $325,000 in our stock portfolio at no/low tax. Then I chose to pay more tax to raise our basis an extra ~$100,000 before returning to the US. High basis means our taxable income stays low even as we regularly sell stock.
There were opportunities to tax-loss harvest along the way when the market was down, of course, but it would have been a wasted gesture – we paid zero tax and more deductions wouldn’t change that. Plus, any realized loss would just be neutralized by the next gain harvest.
I Want Stock at High Basis
Your basis in an investment is what you paid for it, including transaction costs. If you pay $10,000 for shares of $X, your basis is $10,000.
Basis is important when selling stock. If basis is high then more of each sale is a tax-free return of capital / less of each sale is a taxable capital gain.
This chart from the post Long Term Long-Term Capital Gains shows this visually.
When I sell $10,000 worth of stock, I prefer the realized capital gain to be closer to $1,000 than $5,000.
The difference can mean us paying $1000/year for health insurance vs paying $1,000 PER MONTH, which seems important.
(See: Obamacare Optimization in Early Retirement.)
This is why I have spent the last decade aggressively capital GAIN harvesting. I want stock at high basis.
But… tax-loss harvesting does the opposite. More of each sale is a taxable gain.
And this is where my thinking on this had stopped – as an expat I never needed to think beyond the basic idea that high basis was best.
High Basis / Loss Carryover Combo
When I decided I would not tax-loss harvest, this is what I was missing…
High basis is great. But the combination of high basis with a capital loss is actually SUPERIOR.
I can take the full sum of losses across the portfolio and then apply that as a deduction against only the shares we sell.
Even with high basis – over time, the amount of taxable income on a $10,000 stock sale increases as stock prices rise. We shift to the right on the basis chart.
But with the combination of a capital loss… we truly can have a zero income scenario on portfolio withdrawals, possibly for many years.
Even with high basis, as stocks go up we still get a non-zero capital gain on stock sales, even if small. But we also have a capital loss… we truly get a $0 income scenario on portfolio withdrawals.
Sell $10k of stock that has doubled in value -> $5k taxable gain.
Or – tax-loss harvest $50k across the portfolio, setting basis on many shares 25% lower
Sell same $10k stock -> $6,250 taxable gain – $6,250 tax-loss = zero income / no tax
The typical Early Retiree Scenario à la Go Curry Cracker
This year (2022) the market is down 25% +/- and I have the opportunity to tax-loss harvest.
Ironically I only have this opportunity because of significant capital gain harvesting in prior years and choosing to invest a recent mortgage. As such, I have about $50,000 in losses I could realize.
We are a low-income household so we pay no federal income tax. Any tax due is wiped out by deductions and credits.
But we do pay California state income tax and ACA health insurance premiums, both of which are a function of income.
I have already sold some stock this year to get cash to fund my Roth solo-401k ($20,500) and his/her Roth IRAs ($12,000.) In doing so I realized a loss of ~$4,000 and will most likely have a full $3,000 deduction against ordinary income. For clarity – the goal was to fund retirement accounts; a deductible loss was a side-effect (although I was careful to avoid the wash sale rule – can’t buy similar asset 30 days before/after.)
This $3,000 loss will save us about 4% on California taxes ($120) and 10-12% on our insurance premiums for the year (~$330+/-.) Technically this would also save us 10% on federal income taxes, but all it does in practice is lose an equal amount in Child Tax Credits.
I fully appreciate saving ~15% and having an extra $450 in my pocket. If I didn’t, I could do a $3,000 Roth conversion to bring us back to the same position. Who doesn’t love tax-neutral Roth conversions?
So why not realize an additional loss of $46k to carry forward? Or if not the full amount, surely a few years’ worth * $3,000? After all… if the market recovers, this opportunity will disappear along with the loss.
Surely tax-loss harvesting can’t be the perfect tax minimization tool… there must be some negatives or risks?
There are at least 3 (which I seldom see discussed in the tax-loss harvesting guides.)
Loss of Capital Loss Carryover
One of the best features of tax-loss harvesting is the loss carryover – if you don’t use all of your deduction this year you can use it next year. Or any year.
But it would be a bummer to go through the work of tax-loss harvesting and have your capital loss carryover disappear over time with zero benefit. Or worse, get a higher tax bill due to that lower basis thing I mentioned.
If you generally pay zero tax on capital gains and/or are a lower income household such as ours this is a real possibility (external link.)
Example 1 – early retiree / lower income household
This year maybe I tax-loss harvest and realize a $10,000 loss, lowering our basis by the same $10k. Without any capital gains, $3,000 is used to offset our ordinary income from interest/blog/job/non-qualified dividends, and $7,000 carries forward for future use.
Next year income overall is low and I sell some stock to get our spending money. Income is less than ~$100k so our dividends and long-term capital gains are taxed at 0% (at the federal level*.)
The capital loss carryover offsets some of our capital gains that were not taxed anyway and is gone forever.
In year 3 I sell some more stock to buy a boat, which means selling a bunch of shares including those I tax-loss harvested earlier. With $10k lower basis we have to pay some extra tax.
Example 2 – capital gains distributions
Maybe you don’t plan to sell any stock for the foreseeable future so you aren’t concerned about wasted capital loss carryover.
But then… BAM, your index funds distribute some capital gains (external link.) In December. With minimal notice and no time to do anything to compensate.
Because income is low this would have been an untaxed distribution… but it wipes out the carryover.
* the capital loss carryover and associated lower gross income may still help with state taxes or health insurance premiums.
Higher Future Taxes
Not a week goes by where I fail to see somebody starting a sales pitch with the phrase, “Since taxes are going to go up in the future…” (probably a whole life insurance guy.)
Maybe taxes are going up, maybe they aren’t. But tax laws don’t need to change in order to pay more taxes in the future due to tax-loss harvesting.
This year a small capital loss might save us 4% on State taxes and 10-12% on ACA premiums. That is a ~15% tax increase over the 0% we would have saved from a loss a few years ago.
If we managed to carry forward our losses undisturbed for many years… to a date when we are collecting Social Security and perhaps start to face RMDs, the ~16% we could save today could easily reach the maximum capital gains tax rate of 23.8%. (Because of tax deferral this isn’t a guaranteed loss… time value of money, etc… We are 25 years away from RMDs so even a minimal return will make a 16% savings now the right choice.)
Complete loss of tax-loss due to IRA dividend reinvestment
A lot of “how to tax-loss harvest” guides start with this phrase: completely disable dividend reinvestment in ALL of your accounts. This includes your spouse’s accounts!
Which is fine… maybe you like another monthly/quarterly item on your to do list or to hold uninvested cash in your IRAs.
This is because of wash sale risk, a part of the tax-loss harvesting nuance. This says if you buy a substantially identical investment 30-days before or after realizing a capital loss, the loss is washed away – no tax deduction this year and no adjustment to basis (unless you also sell the shares that caused the wash sale.) A common cause of a wash-sale is the reinvestment of dividends…
Now… if this purchase occurs inside of an IRA… the loss is washed away FOREVER. There is no adjustment to basis in your IRA and you will be taxed on the full value upon withdrawal.
In theory, this is difficult for the IRS to enforce. They don’t get a record of all of your IRA transactions (as of today.) But in an audit situation they very well could uncover a wash sale.
For an example, see the Investopedia article, Can IRA Transactions Trigger the Wash-Sale Rule? (external link)
As an expat with no tax burden, I didn’t see the value in tax-loss harvesting. Any tax-loss would just be offset by my next capital gain harvest.
But as a US resident with State and ACA tax burden, tax-loss harvesting is a big win. We can benefit from ordinary losses for several years AND increase the number of years where we can sell shares with no/low capital gains.
It isn’t all guaranteed and risk free, but we can avoid what I see as the 3 main risks.
I am absolutely tax-loss harvesting.
Thanks to readers Dan and Mighty Investor for the valuable feedback!
Greetings from Toronto, Canada. What would be a different fund for ZCN that would be a non-substantially identical investment? Thank you!
Dunno. Maybe VCN. It just needs to track a different index. This is the first thing that comes up on google.
Very timely post since I’m in the same situation this year. I might have about $30k in losses from my trading account this year. I would like to offset these losses by doing a taxable event from converting some of my trad ira to roth ira. My understanding is capital losses can offset Roth conversion income only up to $3,000 a year. For my case, I can’t use a $30,000 capital loss to offset a $30,000 Roth conversion. It can offset only $3,000, and the rest of the loss is carried over to future years. Is this correct?
yes, correct – if you have realized capital gains those get offset first.
If you have $30k in capital losses can you skip a year, or multiple years, utilizing the losses to offset your ordinary income? For instance, use $3k of the losses to offset $3k of income for TY 2022 but not use any for TY 2023 then use another $3k for TY 2024?
Any unused capital loss is carried forward, yes. If you have no capital gains in taxable accounts in 2023 (including MF distributions) then it will carry forward to 2024 -> See the part of the post above where it shows you can lose some portion of the carry forward
Regarding ‘use $3k of the losses to offset $3k of income for TY 2022 but not use any for TY 2023 then use another $3k for TY 2024?’
My understanding is that $3000 of a loss carry forward must be applied against income every year, assuming there is income, just as the loss carry forward must be applied against any capital gains, even if those gains would have had a 0% tax rate.
Yes, this is correct. You can’t choose to NOT apply the loss carry forward.
The way I interpreted the question was that 2023 would be a low/no income year with no capital gains. In that case the full carryover would continue to the next year.
The capital loss carryover is reduced by the amount that it actually reduces your taxable income, but other deductions (e.g. the standard deduction) are applied first… with low income the deduction applied by the tax loss would be zero. This is how the Capital Loss Carryover Worksheet would crunch the numbers (see instructions for Schedule D or Pub 550.)
we sold our airbnb property this year with substantials gains – around 200K, even though we lived in 50% of the property for two of the last 5 years. I am considering selling off some old bad stocks from riskier days that have been sitting there waiting to offset a large capital gain. our combined income is lower since a layoff in 2021 (60k), but that still leaves us with the taxable gains of 160k(ish).
Is it really possible to take 60k in capital losses to bring taxable gains down to 100k? It feels too good to be true. Thank you!
Yes, if you realize $60k of losses you can deduct that from the gains. There is no limit.
thank you, this is good news and timing :)
IRA’s are tax deferred investments. The sales within an IRA are not reported for tax purposes. Therefore wash sale rules are not relevant within IRA. The wash sale rules prevent a taxpayer from taking a tax loss on a sale that is a “wash”, but in an IRA you weren’t taking the tax loss anyway. And in a taxable account, the loss that you can’t take due to wash sale rules IS an adjustment to basis. It preserves the benefit until the stock/fund is sold later.
No. Read the link.
Got it! I didn’t read/understand your post as referring to selling in a taxable account and repurchasing in an IRA. In that context you are absolutely correct!
Thanks for confirming! Sorry for the brevity of the previous reply, I was on my phone.
Re-reading your comment, you are also absolutely correct when we exclude this specific scenario.
So wait, sorry… I don’t have to turn off automatic reinvestment of dividends in our IRA’s if they’re the same funds I plan on TLH’ing?
You do. Or plan around it.
Great rundown! I’ve been doing the same thing. After leaving my financial advisor I was stuck with a bunch of individual stocks that all had tremendous gains.
Even with the markets down the stocks have been owned long enough to still be showing gains for days.
Finally, I realized I could harvest losses, sell many stocks for gains and end up with a net zero effect.
I’ll continue to sell off more stocks and load up on safer index funds. A huge benefit of the markets being down turns out to be tax loss harvesting and re-elvaluating your portfolio!
This is a great use of tax-loss harvesting.
We are now fully tracking on this. Welcome to my world!
Perfect, thanks again!
Thanks for another in-depth article. To clarify a point of confusion for me and potentially others: a wash sale only applies to the amount bought within the wash sale period. For example, if you sell 100 shares of VTI for a loss and your brokerage automatically reinvests a dividend of 4 shares for that quarter, you can still claim the loss on 96 (100 – 4 = 96) of the shares sold at a loss. Reference: https://www.irs.gov/publications/p550#en_US_2021_publink100010608
Yes – if you harvest a $10,000 loss and then buy $1 worth of substantially identical shares, you don’t wash the whole $10,000. And if you sell the washed shares you are also in the clear.
By “if you sell the washed shares you are also in the clear,” do you mean that you recoup the previously washed loss due to the now higher cost basis ($1 in your example) of the washed shares?
And does that somehow apply to selling washed shares in an IRA? (Frankly, I’m not sure it makes any sense to call shares in an IRA washed.)
2 different things
Taxable only – if you tax-loss harvest and break the wash sale rules, you can recover that by selling the violating shares.
IRAs – there is no way to recover
You sell 1 share of stock/ETF/MF for less than you paid for it. In your IRA you purchase 1 share of the same investment (intentionally or no.)
Your basis in the taxable account is permanently lower with no tax deduction.
What word or phrase would you use to describe that?
Thank you. That’s very clear now. I would still call those shares “washed” in the case of purchased shares in an IRA within the wash sale window. “Permanently washed” maybe communicates the full tax implication.
Off to turn off reinvestment in my IRAs. I turned them off 20+ years ago in taxable accounts but didn’t understand the nuances of wash sale rule on retirement accounts.
I don’t see this really being an issue depending on your holdings of course – if they pay dividends monthly then yes it would be. But VTI for example pays dividends quarterly. Do your harvesting in the months that don’t contain end of quarters and no worries.
As noted in the comments above though (and this was a breath of fresh air) the wash sale rules only apply to an equal amount of shares to what you purchase. That’s peanuts for me when it comes to dividend reinvesting.
You harvest losses when the market is down. That isn’t guaranteed to fall conveniently in mid-quarter between dividend distributions.
re: peanuts – the loss is washed away forever. I wouldn’t ignore this any more than I would refuse to pick up a $20 from the sidewalk.
I guess some clarification then might be in order… Is my $15 quarterly dividend auto-reinvestment washing away the ENTIRE loss of say $5000 that I would have gotten if I’d have sold when I first read this article as opposed to observing the waiting period to avoid wash sale rules? Thanks for any clarification!
Not that it changes the principle of the question but make that $150 on the quarterly reinvestment.
This article could not have been more timely. We borrowed at very favorable terms to invest at the beginning of the year (you know, while the market was “down” from the mere threat of a war in Ukraine) and purchased mostly VTI. I invest whenever there is a little extra money in my bank but thankfully my recent purchase had all been small and mid cap indexes and I’d been moving towards a cap-weighted three fund portfolio so hadn’t purchased VTI since end of September, but thanks to this article I reviewed all of my other accounts. Sure enough, my HSA was set to VTI and I was able to change it over THE DAY before the next purchase went out. I’m planning on harvesting a bunch of those early year VTI purchases as soon as I hit the 30 day mark at the end of October. Wouldn’t have bothered with any of it if I hadn’t read this article ;)
I never understood tax loss harvesting. If my shares are down 50%, why would I sell now and lock in those losses? Do you intend to buy different stock to ride that back up while also using the 50% loss to lower taxable income? Why not just wait till the shares go back up in price so you’re not actually losing anything?
This sounds like buying high and selling low which is something I thought you’d never intentionally do.
Harvesting gains makes total sense though.
>Do you intend to buy different stock to ride that back up while also using the 50% loss to lower taxable income?
This is the definition of tax-loss harvesting.
Nothing* changes except on paper.
* Well… maybe a little something. Portfolio should be 99.9% the same
I keep reading about tax loss harvesting and still get very confused about the implications of its use. Not so hypothetical scenario: I left my US employer last year and converted my 401k to a traditional IRA at the height of the market. Now I’m working for an AUS employer and my 2022 US income will be $0 due to FEIE. Could I say sell a portion of my traditional IRA to do a Roth conversion? And since the basis is now lower than when I bought in my tax liability will be lower due to tax loss harvesting?
Ah never mind… just reread and saw it was for taxable accounts!
You live in Australia now?
You can do a Roth Conversion at zero or low US tax rates (may still be taxed in Australia.)
You get the FEIE and the Standard deduction, both.
I did this in 2020, see our tax return as an example and explanation: https://www.gocurrycracker.com/go-curry-cracker-2020-taxes/
If anything is unclear, please ask.
Yes I’ve been living in Australia for a year but I’m not considered a resident due to my current temporary visa status. I think I’m still technically considered a resident of Colorado. Would the state taxes and early penalty be worth the conversion?
Thank you for supplying your 2020 tax documents. It helps to see how it could be done.
There is no early penalty – it’s a conversion not a withdrawal. You move $ from a Traditional IRA to a Roth IRA, paying taxes on the sum you move.
If you are outside the US you are a non-resident for tax purposes. For Colorado… they have their own rules…
With a flat 4.65% CO tax rate, the question to answer is… is that rate lower than you would pay on IRA withdrawals later in life? 4.65% is fairly low… the answer very well could be yes.
I would personally be happy to pay 4.65% now vs 12-22%+ later.
Ahhh… light bulbs going off. Thank you for the help!
Combining tax loss harvesting with charitable donations sweetens the deal. Harvest the loss today, then wait at least one year and donate the (hopefully) appreciated shares and avoid paying the capital gains.
Is the question of TLH just a simple question of current capital gain tax rate vs future capital gain tax rate? i.e., if we think future cap gains tax rates will be higher than current cap gain tax rate, then, we will want to NOT TLH, and vice versa?
That is a significant part of it, but you also need to consider the gains not made because of taxes paid now. Also when you die… inherited share basis is stepped-up to market value, so you don’t want to pay taxes in advance on any shares you plan to bequeath.
If a married couple earns less than ~$100k/year then the federal cap gains tax rate is 0% – hard for rates to go down (state and ACA taxes apply.)
btw I think you meant if rates higher then DO TLH now.
Ahh. good positive points about stepped up basis and the 0% cap gains rate bracket.
If I am squarely in the 24% bracket around 140k for a single person, is there still an advantage to tax loss harvesting? I am about 6 months to a year from FI, does this benefit me? Sorry, there are a lot of angles here, just trying to see them all. Thank you!
Yup. 24% * 3000 = $720 this year.
Then that would reset my basis on those shares correct, and give me a little tax break. If for example I sold shares of VTI, What would be a solid purchase to avoid the wash sale? Should I pause my re-investments for 60 days? Thank you!
It would, yes. Reset the basis to a lower level.
Some alternatives: VOO (SP500), ITOT (total market), IVV (SP500), SPY (SP500)
If we have qualified dividend, interest income and W2 income, is it correct that the $3000 loss will offset the qualified dividend first?
No. Dividends and capital gains are different categories
I think I’m the early retiree example you cited under risks. I’ve been capital gain harvesting at 0% for the past two years while living abroad (Thank you!) but just returned to the US. I’ve already made my capital gain sales earlier this year (while overseas to avoid state taxes) so don’t think I should TLH this year as it would just offset my already 0% taxable gains and not carry forward. I expect to have a lot of medical expenses next year and intend to reduce our capital gain harvesting next year in order to get a bigger ACA subsidy (and avoid selling in a down market–I have a couple year’s expenses in cash). Am I right in thinking TLH wouldn’t be prudent this year as it will just match off against my 0% taxable gains, leaving no loss carryforward? TLH might make more sense for me next year when I recognize fewer gains and want to minimize income for state tax and ACA subsidies.
Yes, any realized losses before 12/31 will just offset the 0% realized gains.
As a US resident, realized losses on 1/1+ will help.