The past several weeks have been rough for investors. However, the increased volatility and market pullback has brought an opportunity to taxable accounts: tax-loss harvesting.
What is Tax-Loss Harvesting?
Tax-loss harvesting is when an investor sells a security to recognize capital losses and buys a replacement security. Ideally, the replacement security helps the portfolio maintain the same characteristics as the sold off security (asset allocation, expected return, risk level etc.).
For example: an investor with exposure to 50 companies in her portfolio may decide it’s worth selling Coca-Cola (KO) at a loss and buying Pepsi (PEP). Although they are two different companies, they tend to move in unison. More importantly, the impact of holding Pepsi over Coke should be immaterial for the overall portfolio composition.
This strategy can also be employed with Mutual funds or ETF’s. An investor can sell an ETF of the S&P 500 index such as SPY for a Russell 3000 ETF index such as IWV. Although these are two different ETF’s and they follow two different indexes, the correlation between them is extremely high.
Why Buy a Different Security?
If an investor sells a security at a loss and buys the same security within 30 days, then the initial sale is called a “wash sale.” A wash sale temporarily disallows an investor from taking the capital loss. Instead, the disallowed capital loss is added to the cost basis of the replacement security. The IRS implemented this rule to discourage investors from selling a position to incur a capital loss, and then buying the same position shortly thereafter.
What are the Benefits of Tax-Loss Harvesting?
When there are pullbacks like we’ve seen in Q1 of 2020, an investor can build up substantial capital losses. These can be used to offset capital gains in the same year. Individuals can deduct up to $3K of net capital losses in a single year. More importantly, capital losses carryover indefinitely into future years. So, a quarter like Q1 of 2020 can help you build capital losses to last for many years.
The Downside to Tax-Loss Harvesting?
Implementing a tax-loss harvesting strategy can be complicated, there are several issues to watch out for, as outlined below:
Substantially Identical: The IRS states that a wash sale will occur if an investor buys a “substantially identical,” (Publication 550) security within the 30-day timeframe of a security sale. The definition of a substantially identical stock is black and white. However, when it comes to Mutual Funds, ETF’s and derivatives, there is definitely some interpretation and grey area. For example: iShares’ SPY and Vanguard’s VOO both follow the S&P 500 index. However, the underlying positions are not 100% identical. In my opinion, they are substantially identical and I would stay away from swapping them for tax-loss harvesting benefits.
Portfolio drift: When completing tax-loss harvesting transactions, an investor must be careful of portfolio drift. By consistently replacing security positions that are slightly different, over time, the characteristics of the investment portfolio could become considerably different. A common strategy is to switch back and forth between the same two securities while avoiding wash sales.
Permanently Disallowed Loss: A wash sale can also occur if you sell a position in your taxable account and purchase the same position within 30 days in your retirement (qualified) account. Since the custodians do not track this, it’s the investor’s responsibility! What’s scary is, if this happens, the wash sale becomes a permanently disallowed loss, meaning the investor never gets to realize the loss.
Trading Friction: Many custodians have done away with trading fees on stocks and ETFs, however forms of trading friction still exist. One example is the spread between the bid and the ask price of a stock or ETF. If it’s $0.10, an investor needs to ask themselves if his is willing to give up a dime per share to complete the transaction ASAP or if he’d prefer to be patient? Another form of trading friction is time. The time that it takes to move out of one position and into another can be time that cash sits idle on the sidelines, missing a market climb.
Tax Rates right now are below historical averages. When you tax-loss harvest, you are deferring taxable gains to future years. If tax rates are increased in the future, there is the possibility that you’ll have to pay more in taxes then, as opposed to what you are saving now.
Is Tax-Loss Harvesting Worth It?
Despite some of the downsides and complications, I am an advocate of tax-loss harvesting. There are several more intricacies that go beyond the scope of this article, but I believe if an investor can be patient, selective and creative, there are opportunities to tax-loss harvest in most market conditions over time.
At Schupak Financial Advisors, we are constantly looking to tax-loss harvest in client’s portfolios. If you want to discuss what we can do with your portfolio when it comes to tax-loss harvesting, Schedule a Meeting Here.