Tax-loss harvesting is all the rage these days. I've done it several times since the start of this bear market and booked hundreds of thousands of dollars in tax losses. However, there are a few reasons why you may not want to do it. Before I get into them, let's briefly review the concept.
What is Tax-Loss Harvesting?
You are allowed to deduct up to $3,000 per year of a short or long term capital loss from your ordinary income on your taxes. Losses also offset gains. This all takes place on Schedule D of IRS Form 1040. These losses are so useful that investment advisors, tax preparers, and financial gurus the world over recommend you book them any time you can.However, taxable losses generally show up after an investment goes down in value, not exactly the time you would normally sell an investment. Buying high and selling low is a losing proposition most of the time. Thus the birth of tax-loss harvesting. When tax-loss harvesting, you get to claim the loss without ever selling low. You do so by simply exchanging one investment for a very similar (but, in the words of the IRS, “not substantially identical”) investment. Thus you're still fully invested (and so haven't “sold low”) but still get to use the loss on your taxes.
An Example of Tax-Loss Harvesting
A typical exchange might be to swap the Vanguard Total Stock Market Fund for the Vanguard 500 Index Fund. These two funds have a correlation of 0.99, but nobody in their right mind could argue they are substantially identical. The first holds thousands of more stocks than the second, they have different CUSIP numbers, and they follow different indices.
So perhaps you bought the Total Stock Market Fund with $10,000. Then a bear market happens. Your investment is now worth $7,000. So you put in an order to exchange it to 500 Index Fund. The next day you discover you own $7,000 worth of 500 Index Fund. The bear market recovers and you now have $10,000 worth of 500 Index Fund and you have a $3,000 tax deduction. That's like making $1,000+ in cold, hard cash.
So if tax loss harvesting is so awesome, why would anyone NOT want to do it? Well, there are a few reasons, including some classic mistakes, pretty much all of which I have made myself at some point.
# 1 Wash Sales
The biggest reason not to tax loss harvest is if you won't be able to get a loss out of it anyway. This often happens if you perform what is called a “wash sale.”
A wash sale is when you buy the shares back within 30 days (before or after) the date you sell them. If you do so, your tax basis (i.e. what you paid for it) is carried into the new shares. So essentially, if you do an exchange to tax loss harvest, you can't go right back to the old investment the next day. You have to wait a month. Note that this wash sale period also includes the 30 days BEFORE the exchange, which makes things a little confusing. It doesn't mean you can't exchange something you just bought. It means you can't buy new shares and then sell the old shares and claim the loss.
Three examples to illustrate the point:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange Fund A for Fund B.
You now have a $10,000 tax loss. No wash sale.
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares. You now have $180,00 and 20,000 shares of Fund A
- Day 6: You exchange 10,000 shares of Fund A for Fund B.
You have no tax loss. This was a wash sale.
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You buy another 10,000 shares for $90,000. You now have $180,00 and 20,000 shares of Fund A
- Day 6: You exchange 20,000 shares of Fund A for Fund B.
You now have a $10,000 tax loss. No wash sale.
# 2 The 60 Day Dividend Rule
Frenetic tax-loss harvesting often causes an investor to fall afoul of the 60-day dividend rule. If you don't own a mutual fund for at least 60 days inclusive before and after a qualified dividend is paid, that dividend becomes unqualified. So now you will pay tax on it at your ordinary income tax rates rather than the lower qualified dividend rates.
Again, an example:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 3: Fund A pays a dividend of $500
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange them all for Fund B.
Now instead of paying $500 * 23.8% = $119 on that dividend you pay $500* 37% = $185. If you had made the exchange on Day 61, that dividend would have been qualified.
Class III rapids? No problem for these kids.
In order to avoid running afoul of this rule, you need to know when your investments are going to pay out qualified dividends and avoid frequent tax-loss harvesting around those dates. You could wipe out the entire benefit of tax-loss harvesting in additional dividend tax costs.
# 3 Tax-Exempt Interest Reduction
I'm hesitant to wander this far out into the weeds lest it keeps some people from doing tax-loss harvesting they probably should do. But I'm going to do it anyway in the interest of accuracy.
If you acquire a loss on shares of a mutual fund you have held for six months or less, then the loss is reduced dollar for dollar by any tax-exempt interest paid during that period. However, most tax-exempt funds are not subject to this rule because of the way they accrue and payout interest (i.e. as dividends rather than interest.) The Bogleheads advise:
To see whether a fund is exempt from the six-month rule, check its prospectus for the statement, “dividends are declared daily and paid monthly”; if it says “dividends are declared monthly” (or quarterly), the six-month rule applies.
# 4 Short Term Loss May Be Ruled Long Term
While we're in the weeds, let's cover this topic. Again, if you hold a fund for less than six months and it distributed long term capital gains during that time period, your loss is long-term and not short-term on an amount equal to that distribution. That usually doesn't matter much since either can be used to reduce your taxes, but technically you are supposed to report it that way on your tax return. To make matters worse, Vanguard (and probably most brokerages) don't keep track of this for you as you would expect. So the 1099-B they send you is wrong and you're supposed to correct it yourself by filing Form 8949 and changing the type of capital loss. Frankly, I really doubt the IRS cares much about this and I don't know anyone who would bother to do this, but it is the correct way to report things.
# 5 Might Cause Bad Behavior
Let's get out of the weeds now and get into some useful information.
When it comes to successful investing, the investor matters more than the investment. Your behavior in a bear market will have a direct impact on your returns, your retirement date, how much you can spend, and how much you can give. Staying the course and doing nothing in a bear market is a great way to not do the classic “buy high and sell low” behavior investors, especially physician investors, are famous for.Some people go to an extreme, deliberately locking themselves out of their investing accounts to prevent them from panic selling, not even opening their brokerage statements, and other similar behavioral techniques.
One big issue with tax loss harvesting is it forces you to pay attention to what the markets are doing and actually look at your accounts. If doing so causes you to have to use a less aggressive asset allocation or heaven forbid do something stupid (like selling low) while you're in the account, you would definitely have been better off never tax-loss harvesting at all.
# 6 You Were Only Deferring the Taxes
When you tax loss harvest, you are also lowering the basis (i.e. what you paid for the shares) of your investment. When you eventually sell that investment, you will owe taxes on a larger proportion of the value. An example might illustrate this:
- Day 1: You buy 10,000 shares of Fund A for $100,000
- Day 5: Fund A drops in price from $10/share to $9/share, so your investment is now worth $90,000. You exchange Fund A for Fund B.
- Day 9,472 You sell your 10,000 shares of Fund B for $250,000. You will owe the following in taxes:
- ($250,000 – $90,000) * 23.8% = $38,080
If you had never tax loss harvested, you would owe the following in taxes:
($250,000 – $100,000) * 23.8% = $35,700
In essence, you now owe $2,380 in additional taxes because of your tax-loss harvesting. That's not necessarily a bad thing, but it depends on what you exchanged it for. Ideally, you were able to use that $10,000 tax loss against ordinary income over 4 years. Saving 37% on taxes and then only paying 23.8% in taxes is a winning move. Same thing if you were able to use the losses against a short-term gain. But even if you were only able to use the losses against long term gains, you still benefit from the use of that money earlier in life, the time value of money if you will. If there were 10 years between when you tax loss harvested and when you sold, and you earned 8% on whatever you invested your tax savings in, that $2,380 in deferred taxes was really worth an extra $2,102.
=((FV(8%,10,0,-2380))-2380)*(1-23.8%) = $2,102
Ideally, you NEVER recapture those losses by either donating the now appreciated shares to charity instead of cash for your charitable contributions or you leave those shares to your heirs to benefit from the step-up in basis at your death. Then you (and your heirs and/or favorite charity) benefit from not only the time value of the deferral of taxes, but also the saved taxes themselves.
# 7 You Should Have Been Tax-Gain Harvesting
A lot of people may not realize this, but if you are not a high-income professional, you may not actually owe much at all in taxes on your taxable investment account. Take a look at the tax brackets for a couple filing “Married Filing Jointly”:
These are also the brackets for qualified dividends. As you can see, if your taxable income is below $80,000, there is no tax due on your capital gains. Don't get me wrong, even with an income under $80,000 you can still use a $3,000 tax loss on your taxes, but it'll only be worth a maximum of $360 given your low tax bracket. If you expect to be in a higher capital gains tax bracket later when you sell these shares, you may wish you had not lowered the basis in your investment just for $360. In fact, lots of people in the lowest tax bracket actually do just the opposite of tax-loss harvesting. They harvest gains by realizing them unnecessarily, constantly increasing the basis on their investments to lower their eventual future tax bill.
# 8 You Already Have More Losses Than You Will Ever Use
Obviously the first $3,000 per year in tax losses that you can use is the most valuable. And of course, you can carry these losses forward indefinitely. They can be used to offset capital gains and could potentially be very valuable at the time of sale of a small business. But at a certain point, a person could have more tax losses than they will ever use.
For example, as I write this post, I have around half a million dollars in tax losses on the books. Obviously, if all I was ever going to be using those for was to offset $3,000 a year of ordinary income, I would have to live another 167 years, which seems unlikely.
So why would I keep accumulating these losses? Well, I used $30,000 in losses in 2019 to offset a short term capital gain I felt was wise to realize, but more importantly, I own all or part of several highly appreciated small businesses that I expect to sell at some point prior to my demise. Up to half a million dollars from those sales will be tax-free. But if you have more losses than you will ever use, there is no point in harvesting more. Remember that losses must be used up by the year the taxpayer dies or they disappear forever.
# 9 You Might Get Burned by Volatility
One of the biggest problems with tax loss harvesting is that it is most useful in the biggest of bear markets. Unfortunately, that is also when markets are most volatile. If you are not careful, or simply not lucky, that volatility can burn you. Let me give you an example of when this occurred recently to me.
I had already tax loss harvested from the Vanguard Total Stock Market Fund to the Vanguard Large Cap Index Fund to the Vanguard 500 Index Fund, all in less than 30 days. And the market had dropped another 15% since. I was sitting on huge losses that I wanted to capture.
I decided the easiest thing to do would be to exchange from the 500 Index Fund to the iShares Total Stock Market ETF. Unfortunately, ETFs trade in real-time, not at market close (4 pm Eastern) like traditional mutual funds. So in order to make this swap, I had to buy the ETF while the market was open and put in an order to sell the mutual fund at market close. So I waited until the end of the day. It was a very volatile day like many of those in a bear market. 15 minutes before market close I bought the ETF. The market was down 9.5% on the day at the time. Unfortunately, in those last 15 minutes of the trading session, the market dropped another 1%+. So I bought high and sold low.
I was unlucky. It could have easily gone the other way, but the difference ( I did something similar with my international stock holding at the same time) worked out to be about $25,000. Is it worth $25,000 to book a several hundred thousand dollar loss? Probably not.
Bear markets and particularly the end of the trading day are notorious times for market volatility. It is best to avoid buying and selling at all during these time periods. So if you choose to wander into that type of environment to do some tax-loss harvesting, don't be surprised if you also get burned.
A great way to avoid this is to use traditional mutual funds in your taxable account. That way you can put in your exchange order and at 4 pm, one fund is sold and one fund is bought. No potential for loss (or gain) on the transaction. But since ETFs tend to be more tax-efficient than traditional index mutual funds (except those of Vanguard which have an ETF subclass), most savvy investors have ETFs in their taxable account.
Thus, you must wander into these dangerous markets if you wish to reap those tax losses. You can try to mitigate it by putting in the buy and sell orders almost simultaneously, but if you use limit orders in a falling market, you are likely to get your buy order filled but not your sell order. Using a market order can also deliver surprises. And of course, the bid-ask spreads tend to widen in times of extreme volatility. Sometimes you'll win, sometimes you'll lose doing this, but be aware of this risk of tax-loss harvesting using ETFs.
As you can see, tax-loss harvesting is a great thing, but it can be more complicated than you might think at first glance, and there are times when you shouldn't bother doing it at all. I've made four of these mistakes myself over the years.
What do you think? How many of these mistakes have you made while tax loss harvesting? Share your tax-loss harvesting success and failure stories below!
