Tax Loss Harvesting - "Making Lemonade out of Lemons"

When is the last time you cheered when the market dropped 5%?  At first blush, a market correction isn't intuitively a reason for a "Woohooo!"  Look again, however, to find that these downturns actually provide great opportunity.  While it's true that they offer an entry point for cash 'on the side' that may have been waiting to be invested, more importantly, they provide the conditions to aggressively Tax Loss Harvest (TLH) your portfolio. Below is our primer on this valuable strategy.

The Goal:

Our goal is to help clients avoid ever having to pay Capital Gains taxes.  Aggressive Tax Loss Harvesting (TLH) enables us to achieve that goal (in most cases) and more…

The Strategy:

Markets go up and markets go down over the course of an economic cycle, but the long-term trend is “Up and to the Right”, making all downturns temporary.  Why not benefit from the ups and the temporary downs?  We have no control over what the market does or when the swings will occur, but we can control how we respond by taking advantage of both conditions. Essentially, we take what the market gives us by enjoying the economics of upswings, while using the downswings to reduce or eliminate your capital gain tax liability.

When markets are temporarily down, TLH to:

  • Offset realized Capital Gains for the current year

  • Reduce $3000 of Ordinary Income

  • Bank any remainder for use in future years.  There is no limit to the amount which may be carried forward; and, they can be used through the year of your death (2nd to die for couples).

When markets are up, Tax Gain Harvest (TGH) in the most tax-efficient manner:

  • In retirement accounts, to mitigate the need to recognize a Capital Gain in a taxable account.

  • In taxable accounts, to the extent the Capital Gains can be offset with “banked” Capital Losses.

  • To replenish Short- and Medium-Term Portfolios.

  • To rebalance the Long-Term Portfolio back to its target asset allocation.

  • To harvest as many gains as possible at the 0% Capital Gains Rate.

  • To “re-set” the cost basis of selected securities at the higher, current Market Value.

  • To take gains at the 15% Capital Gains Rate if anticipated to be in the higher 20% Capital Gains Bracket (20%) in future years when proceeds will be needed.

When possible, it is better to take Long-Term(LT) Capital Losses, as they provide a tax-rate arbitrage as your Capital Gains Rate (0%, 15%, 20%) is typically lower than your Ordinary Income Rate (10% to 39.6%). You can use the lower LT Losses to offset the Short-Term (ST) Capital Gains and Ordinary Income which are taxed at the higher, Ordinary Income Tax Rate.  However, at the end of each calendar year, it is worth evaluating if taking additional ST Capital Losses - presuming no additional LT Capital Losses are available - will reduce your overall tax bill by offsetting ST Gains, LT Gains, and the allowable $3,000 of Ordinary Income.  If so, we consider this rate trade-off worthwhile.

The Tactics and an Example:

You invest $100,000 in the US Large Cap Stocks asset class by purchasing the Vanguard 500 Exchange Traded Fund (ticker symbol: VOO) which is an Exchange Traded Fund (ETF) tracking the S&P 500 index – an index of the 500 largest US stocks by market weight.

Over the course of time, the market drops 10% (as we expect that it will at some point) and your investment in VOO is now worth $90,000, giving you an unrealized loss of $10,000 on that holding – some refer to this as a “paper loss."

At this point, what are our choices? 

  • Hold the position and wait for the market to rise, riding the long-term trend of “up and to the right.”

  • Sell, recognize the loss, and hold the cash proceeds from the sale.  Now, we’ve harvested a loss which we can use, BUT we’re no longer in a position to ride the inevitable up cycle when it occurs.

  •  Sell, recognize the loss, and use the proceeds to purchase another ETF in the same asset class – US Large Cap Stocks, e.g. the iShares S&P 500 ETF (symbol: IVV).

    • Before the trades, we held a $90,000 position in US Large Cap Stocks via VOO.

    • After the trades, we held a $90,000 position in US Large Cap Stocks via IVV.

    • The asset class position is substantially similar before and after the trades – US Large Cap Stocks – with its long-term track record of “up and to the right.”

    • And, we’ve realized a $10,000 Capital Loss which can be used to offset:

    • $10,000 of Long-Term Capital Gains (at a tax savings of $1,000 to $1,500).

    • Or, $10,000 of Short-Term Capital Gains and/or Ordinary Income (at a tax savings of $1,000 to $3960.)

    • Or, a combination of the above.

    • Cost?  Not more than $21 in trading fees.

    • Would you trade $21 to pick up $1,000 to $3,960 of tax savings?

Some argue that when the market rises, you end up with a Capital Gain and pay the tax savings you made on the first trade, i.e. you’re no better off for having executed the TLH.  We disagree and see the benefits as…

  • Time value of money. The loss can be used immediately (rather than later); and, as we know, a dollar today is worth more than a dollar tomorrow.

  • Offset capital gains. You’ve banked an “asset” (the loss) that you can use when you harvest gains in any asset class which may be underfunded in your asset allocation, not just in the asset class of your original position. Since different asset classes do better (or worse) than others at different points of the economic cycle, you get more freedom for taking gains (and not paying taxes).

  • While we like gains, we don’t like paying the tax on them. This was especially evident during the tech boom (which later busted). People lost a lot of money because they wouldn’t take their gains as they didn’t want to have to pay the capital gains tax.  Instead, they ended up with an out of balance asset allocation and over-dependence upon one asset class which they saw rise (and, then fall).

  • Reduce ordinary income taxes. If you have enough losses available, you can use up to $3,000 of losses to offset ordinary income (your W-2 income) each year.

  • The losses carryforward to subsequent tax years – it’s not a “use it or lose it” proposition in the year you take the loss.