The finance industry is complex and opaque. It’s confusing, and that creates opportunity for professionals to profit. But when you strip away all of the complex terminology, middlemen, and advertising, it’s simple: stock investors purchase ownership in businesses. We pledge our hard earned dollars to a business model and management team we hope will grow the earnings of the business, and in turn, increase the value of the shares we own.
So where does wall street fit into that simple agreement? Right in the middle. You can think of wall street as the wholesale and retailer network for stocks. But instead of selling you shoes or tomatoes, they sell shares. But there’s a key difference with wall street: once they sell you stocks, they charge you ongoing fees for managing or advising you on those stocks.
This matters, because it is the context we must keep in mind when evaluating an investment or strategy that wall street or any financial advisor recommends. Tax Loss Harvesting is one of these often recommended strategies. Financial advisors as well as robo-advisors such as Wealthfront and Betterment offer TLH as one of their core value propositions. It’s one of the primary services financial advisors offer, along with portfolio creation/advising, and portfolio rebalancing.
What is Tax Loss Harvesting?
So what is it? Tax Loss Harvesting is the act of selling stocks you own at a loss, and using those realized capital losses to offset any realized capital gains you had in the tax year. Pretty simple. Each year, the IRS essentially gives you a ‘discount’ on your taxes for any real losses you incurred on investments. How generous of them.
The Tax Loss Harvesting process typically looks like this:
Sell a stock/ETF at a loss
Invest the cash in an equal amount of a similar (but not the same) stock or ETF
Rinse & repeat
Example: say I’m heading into December, and I have invested $10,000 in the ETF SPY 0.00%↑ (tracks the S&P 500 Index). My investment is down 10% since I purchased the shares. To Tax Loss Harvest, I would sell SPY for $9,000, and lock in the $1,000 capital loss. I then purchase $9,000 of VOO 0.00%↑ (tracks the S&P 500 index). These funds are nearly identical in their holdings and performance, but not considered ‘substantially identical’ by the IRS. I can now offset my taxable gains on other investments by $1,000 when I file my taxes for the year.
After doing this, from a portfolio allocation perspective, I have the same allocation to the S&P 500, I just own a different ETF that tracks that index. And I can write off the realized loss on my investment, which previously would have sat in my account as a paper loss. I lost money, but I get some benefit from the loss by saving on taxes.
Note: be aware of the Wash Sale Rule. This says you cannot harvest losses on a stock or ETF if you buy the same stock or ETF back within 30 days of selling it. If you buy the same asset back within 30 days from realizing a loss, that loss becomes ‘disallowed’, which means you do not get to use the loss to offset gains come tax time. This is the IRS’ way of making sure folks don’t sell a stock at a loss and buy it back right away, thus generating potentially infinite tax savings.
So Tax Loss Harvesting is pretty simple, right? Yes it is. Anyone can do it themselves for their portfolio. Don’t let the financial industry confuse you into paying someone to do it for you. It just takes a little bit of planning and attention, and identifying the best counterpart with equal purpose and quality to the asset you wish to harvest tax losses on.
The bottom line is Tax Loss Harvesting is not some magic formula for juicing your investment returns. It is not going to drastically change your results, or make you a better investor. It is simply an optimization, and a way to take advantage of a bad situation by getting some benefit on your tax bill.
Should you do it?
Now that you know what it is, and how simple it is, the question is should you do it yourself? The answer comes down to three things:
Do you have losses to harvest & do you have gains to offset?
Is there an equal counterpart to the asset?
Do you want to spend the time/effort each year?
If you don’t have any unrealized losses, you can’t harvest losses for tax purposes, so that is the first thing to rule out. If you don’t have any losses, good for you, but this won’t benefit you. Next - do you have capital gains to offset? If not, this might not be worth doing if you don’t have capital gains to offset.
If you have an asset with an unrealized loss, you have two choices. Sell the asset at a loss to harvest the tax losses and move on, or purchase a similar asset to maintain your allocation to that particular industry, business size, region etc.
Sell the asset and move on. If you’re selling and moving on, I caution you not to do this purely for tax purposes. In other words, don’t sell a great asset if it’s down, just to save on taxes. You may be letting the tax tail wag the dog, and selling an asset for the wrong reasons, only for it to rebound and cause you to lose out on the upside you gave up when you sold.
Sell the asset and replace it with a similar but not identical asset. If you are planning to maintain your allocation to the same type of asset, you’ll want to be sure you can find something which is nearly identical in purpose, and equal or better in quality. Let’s say you are selling VXUS 0.00%↑ (tracks the total-world international index). You'll need to find an ETF that tracks the total-world index, and has equal quality in terms of management, fees, and liquidity (how much the fund is bought and sold). Again, you're letting the tax tail wag the dog if you buy a fund with a different purpose or that is lesser quality. You get a small tax benefit, but you may change your asset allocation for the worse, or purchase a lower quality fund that underperforms compared to your initial investment, or has higher fees etc.
*Note: Don't overlook liquidity when identifying a counterpart! Large funds like SPY 0.00%↑ have millions of shares traded per day, which keeps the bid/ask spread (difference between buyers and sellers) really tight. Small companies and small funds may not have the same volume of transactions, which broadens the bid/ask spread. This can cost you big time when you sell your shares because the bid may be lower than you think.
Now let’s say in theory you’re heading into the end of the tax year, you do have losses on an asset, and you can find an equal counterpart to the asset. The final question becomes, do you want to spend the time and effort to find that equal asset, sell your asset, and buy the new asset? If so, then harvest away. TLH is a great way to get some benefit from your paper losses when heading into the end of the tax year. Just be mindful that you’re doing it for the right reasons, and don’t let the tax tail wag the dog!