Tax season passed relatively recently (okay, yeah, I’m like 2+ months late) so I wanted to take some time to reflect on my experiences with it this time around. Primarily, I’m going to show how I was able to effectively lower my taxable income and provide myself with a nice hefty tax return this year using Tax Loss Harvesting.
This will have been only my second time doing my taxes and the first time doing it completely on my own via Turbo Tax. (*) The key take away of this point is if you’re nervous about trying this out on your own, don’t be, because if I can do it with my fairly minimal experience, you should be able to as well!
(*) I’m aware that Turbo Tax is into some shady political/financial business and as such will be swapping away from them come next year. I’ll likely move into H&R Block or some other alternative.
What is Tax Loss Harvesting – The Basics?
In my own words, Tax Loss Harvesting is the technique of shielding your cash from taxes by taking advantage of poor market conditions. In more depth, it’s the act of selling off shares of an under-performing asset and replacing them with different under-performing assets.
When you sell an under-performing asset (it has decreased in value since you purchased it) you trigger a “Capital Loss“. This is the opposite of a “Capital Gain“, which would occur if you had sold an asset that had increased in value since purchasing. This action is called “Realizing” your gains/losses. How does this work? Well, normally, every dollar in Capital Gains can be “offset” or nullified by a dollar of Capital Losses. In addition to that, the IRS allows you to offset up to $3,000 in ordinary income (income you’ve made from a job, for example) per year with Capital Losses. This means that it will look like you’ve effectively made $3,000 less than you actually did on your tax sheet. Awesome right?
But what do you do with the funds you now have lying around from selling your asset? Buy back into the market of course! Once you’ve completed your transaction to sell off the under-performing asset you now have the opportunity to purchase a fundamentally different asset right away. Ideally something that is also under-performing currently in the market.
WARNING: Keep reading here before going off and selling anything! There’s a few warnings below!
You might be hesitant about selling an under-performing asset, since all investing advice spouts the same “Buy low; Sell high.” That’s not what we’re doing here though. At the end of the day, you’re still invested in the market at a level similar to your initial investment. Something that is not currently doing too well, yet will still hopefully rally over time. BUT you are also able to tell the IRS that you took an $X loss come tax time next year. This will lower your taxable income for the year and give you a nice boost to your tax return!
Some Caveats to Take Heed Of
After employing this tactic for the first time last year, I experienced some mistakes first hand that cost me a nice chunk of change. I figured I’d let you all know so you don’t make the same mistakes as me. And to reiterate for myself so that I don’t repeat them!
The Wash Sale rule is what prevents someone from selling and re-buying the same asset immediately just to trigger the Capital Loss.
If you purchase the same asset back immediately or purchase a “fundamentally similar asset” you’ll trigger a Wash Sale. Fundamentally similar assets are two different mutual funds which track the same index. Meaning that any Capital Losses you may have incurred will be NULLIFIED. You can, alternatively, choose to wait 30 days and purchase the same asset once again. Some prefer not to wait in case they miss out on any rallies/bull runs in the market over that period. I took this approach as well.
I suggest that if you plan to try your hand at Tax Loss Harvesting that you start removing automatic dividend reinvestment (DRIP) on these funds ahead of time. Either that or pay VERY good attention to the dividend payment dates. There are several dates for each asset to be aware of for dividends. Reinvestment of dividends will trigger a Wash Sale!
Fortunately, the entire value of your loss won’t be nullified in this case. You’ll only miss out on up to the amount of the dividend. In any case, you’d still rather not have to miss out on the extra losses if you just pay attention. Removing DRIP entirely takes this danger out of the equation and is what I have begun doing. I do need to manually reinvest in some of these funds, but for the most part they don’t pay out that often anyway. This makes it simple and these funds can just be clumped in with my frequent investment contributions anyway.
I messed this up last year and missed out on hundreds of dollars of potential capital losses. All because a couple of my funds paid out dividends soon after selling them. I am an idiot. Learn from it!
Start Early and Harvest Throughout the Year
You don’t ONLY need to wait til the end of the year to tax harvest. You can do it at any point throughout the year and you should take advantage of that! If the tax year just started and one of your assets were under-performing heavily it would be a great idea to harvest that loss. You can do so right away since it carries all the way through til when you need to do taxes. This is good because the market can perform in a myriad of different ways through the different points in a year.
The act of harvesting often will allow you to maximize the amount of “losses” you’re “realizing” throughout the year. Another benefit to starting early is being able to catch yourself making any mistakes with enough time to fix them. For me, having more time to plan out my sells and turning my DRIP settings off would have stopped me from triggering Wash Sales. More time might allow you to better plan the new assets you’ll be buying. Either that or determining if you want to wait the 30 day period instead.
Take Advantage of Loss Carryover
As mentioned, the maximum amount in Capital Losses one can use to offset ordinary income each tax year is $3,000.
Let’s say that I’ve sold an asset that net me a total of $20,000 in losses. Additionally, I just so happen to have accumulated $10,000 in Capital Gains from selling some other asset. My net Capital Loss for the year is $10,000 (20,000 – 10,000). According to the rules, I can only deduct $3,000 from my ordinary income.
Fortunately, it’s not a “use it or lose it” deal. The remaining $7,000 in losses can be carried over into any following years to deduct further capital gains AND ordinary income. So if next year I incur a further $4,000 in Capital Gains, I can take from my $7,000 carry over last year to offset those gains. I can also then use the remaining $3,000 to further offset my income! How awesome is that?
So if you end up with a really large loss one year, take advantage of it by harvesting it! It will pay you, literally, in future years to do just that!
Tax Loss Harvesting is a great way to slim down your tax sheet and take advantage of under-performing markets. Financial Independence is much easier to reach when you’re minimizing expenses and taxes is one of those hidden expenses that can really creep up on you.
The better you understand how your money is taxed, the more prepared you will be to be able to shield it! I highly suggest this Mad FI-entist post for further information on Tax Loss Harvesting, but hopefully you’ll have learned something new today!