Tax-Loss Harvesting and Tax-Gain Harvesting Explained
Hi everyone, my name is Tan, and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner at TAN Wealth Management. Today’s educational video is about tax harvesting. Tax harvesting breaks down into two forms: tax-loss harvesting and tax-gain harvesting. The goals of tax-loss harvesting and tax-gain harvesting are to reduce your overall tax liability, avoid or reduce paying taxes on your investments gains, and increase your after-tax returns.
Tax-Loss Harvesting
What is tax-loss harvesting?
Tax-loss harvesting is selling an investment at a loss to realize the loss then reinvest the proceeds in a similar investment. You want to realize the loss for the tax benefits. You want to replace the investment with something similar because when that type of investment recovers, you don't miss out on the gains. In order to do tax-loss harvesting, the investment value has to be below their cost basis.
How is tax-loss harvesting done in practice?
Here’s an example. Let’s say in 2019, you invested $100,000 in a brokerage account, consisting of $60,000 (your cost basis in a Total Stock Market Index Fund) and $40,000 (your cost basis in a Total Bond Market Index Fund).
Due to the coronavirus pandemic, the stock market crash in 2020 and the value of the Total Stock Market Index Fund decreased to $50,000. You sold all of your Total Stock Market Index Fund then used that money to buy the USA Momentum ETF. Your new cost basis is $50,000, which is invested in the USA Momentum ETF. You have a $10,000 capital loss.
You took a realized loss but not an actual loss because you remain fully invested with little changes to your asset allocation. Which means, you realized a loss for the tax benefit, but also stayed invested. When the U.S. stock market recovers, your investment also recovers because you were fully invested.
So what is the tax benefit?
Let’s say you have capital gains to offset, and you are in the 20% long-term capital gains tax rate. Your total tax savings now is $10,000 X 20% = $2,000.
If you don’t have capital gains to offset, you can deduct $3,000 annually from your ordinary income until you use up all the $10,000 capital loss.
Let’s say you are in the 35% federal income tax bracket, and we are not going to include state income tax for simplicity. Your total tax savings is $10,000 X 35% = $3,500. Remember, you are deducting $3,000 in year 1, $3,000 in year 2, $3,000 in year 3, then $1,000 in year 4 from your ordinary income.
The caveat is you are decreasing your investment cost basis. If you want to get the full benefit of tax-loss harvesting, what you do after tax-loss harvesting is critical, and we will go over that later in the video.
What are the benefits associated with tax-loss harvesting?
When you have mutual funds and ETFs, the funds distribute capital gains or dividends, whether you like it or not. That is a taxable event in the year the fund distributes the capital gains or dividends. If you can sell an investment at a loss, you can offset that loss with the fund capital gains or dividends.
Realized short-term capital gains are normally taxed at your highest tax rate in the year the gains are realized. If you can do tax-loss harvesting, the capital loss can offset the capital gain.
It’s the tax benefits you are getting when you do tax-loss harvesting. First, you can offset the capital loss with a capital gain. If there is no capital gain to offset, up to $3,000 annually can be deducted against your current income, not indexed for inflation. If you have excess capital losses after you deducted $3,000 from your income, the losses are carried forward into next year until you use up all the losses.
Reinvestment of the tax savings. Instead of paying taxes on the investment gains, you take that money and invest it in the account so the money can grow over time.
The tax savings in the difference in tax rates between ordinary income tax rates and long-term capital gains tax rates. Short-term Capital gains are taxed at ordinary income, and it’s about 50% for high-income earners. For example, you have $1,000 of short-term capital gain, and it’s taxed at 50%, the tax is $500. You did enough tax-loss harvesting to offset the capital loss of $1,000 with a short-term capital gain of $1,000. Your net tax is $0 because $1,000 loss minus $1,000 gain. Because you did tax-loss harvesting, your cost basis decreased by $1,000. You sold the investment after a year, and the long-term capital gain is $2,000. The highest tax rate for long-term capital gains is taxed at 20%. $2,000 X 20% = $400 which is the tax liability. The difference between ordinary income tax rates and long-term capital gains tax rates savings is $100 ($500 - $400). You can take that tax savings of $100 and invest the money so it can compound over time.
Although you decrease your investment cost basis, you could potentially pay no tax on the investment gains by giving the appreciated investment to a qualified charity. Also, pay no tax on investment gains to your beneficiary when you deceased but subject to estate tax if your estate is over the estate tax exemption limit, which is $11,580,000 in 2020 for a single individual.
Capital losses benefit in the following order:
Gain offset (capital loss – capital gain).
Ordinary income offset (reduce ordinary income up to $3,000 per year).
Tax shield (excess losses carry forward into next year).
The disadvantages of tax-loss harvesting are:
You are decreasing your investment cost basis. When you have to sell your investments, you will have a huge capital gain compared to not tax-loss harvesting. Thus, your tax bracket could increase, and you could be phased out on certain tax deductions and credits. You might also be subject to the additional Medicare surtax of 3.8%, and up to 85% of your Social Security benefits could be taxable because you increase your taxable income.
When you do tax-loss harvesting, you are selling an investment then buying another similar investment. You could be missing out on the investment gains because of the lag that takes from selling the investment to acquiring a similar investment.
There will be transaction costs, such as trade fees and bid/ask spread, whenever you buy and sell investments.
You have a primary investment, and when you do tax-loss harvesting, you are replacing your primary investment with your secondary investment. The secondary investment is not better than your primary investment. That’s why it’s your secondary investment. That’s why when you do tax-loss harvesting, you want to know how long you are going to hold the secondary investment.
Tracking error between the primary investment and the secondary investment.
The opportunity cost is your time because you have to monitor and manage your accounts.
Resetting the holding period. When you do tax-loss harvesting, you are selling an investment then buying an investment. The holding period starts when you buy a new investment.
Other information we should know related to tax-loss harvesting.
Wash Sale Rules:
According to the U.S. Securities and Exchange Commission, “a wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you:
Buy substantially identical securities,
Acquire substantially identical securities in a fully taxable trade, or
Acquire a contract or option to buy substantially identical securities.”
”Within 30 days before or after the sale,” which means you want to sell or trade securities for at least 31 days before or after the sale.
Source: sec.gov
Source: irs.gov
What happens when you trigger a wash sale rule?
You can’t claim the loss on the sale.
The replaced investment cost basis will be adjusted.
The replaced investment will continue with the holding period of the original sold investment.
Be careful with the wash sale rules. The wash sale rules only apply to losses. The wash sale rules could look at all of your accounts and your spouse accounts if you file your tax return with your spouse.
Tax-loss harvesting works on taxable accounts.
Tax-loss harvesting works on taxable accounts like a brokerage account and does not work on pre-tax accounts, such as IRAs, 401(k) plans, 403(b) plans, 457(b) plans and after-tax accounts, such as Roth IRAs and Roth 401(k) plans.
When you look at robo-advisors like Wealthfront and Betterment, their website only shows primary and secondary investments. What happens when they do tax-loss harvesting by replacing the primary investment with their secondary investment then having to do another tax-loss harvesting because the market is down, but they can’t do it because they don’t have a third investment in line? I don’t know if they have the third investment or not because it doesn’t show it on their website. Although it doesn't say it on their website, it doesn’t mean they don’t have it. You always want to do your due diligence and research before investing.
Common mistakes to watch out for when doing tax-loss harvesting:
You should know that the wash sale rules could apply to all of yours and your spouse’s accounts. This means if you sell an investment in your taxable account, then buy the same investment in yours or your spouse's retirement account, you could trigger the wash sale rules.
Don’t sell and be in cash for 31 days, then buy back the investment because you might miss a big gain on the investment. There are a lot of studies that show that if you miss the biggest daily gains in the market, your total returns will be less than someone that is fully invested all the time.
Be careful with automatic dividend reinvestments, automatic investment plan (AIP), and automatic rebalancing. I have seen investors owning the same investments in their taxable accounts and retirement accounts. When they sell the investment in their taxable accounts hoping to incur a loss, the wash sale rules trigger because the same investment in their retirement accounts reinvests the dividend, which uses the dividends to buy the same investments they just sold in their taxable account. This common mistake also applies to selling an investment at a loss in the taxable accounts and automatic rebalancing in the retirement accounts. If you sell all of your shares to realize a loss and you accidentally dividend reinvest or rebalance the portfolio and trigger the wash sale rules, you could eliminate the loss or realize a partial loss depending on your net gain and loss.
Best Practice:
If you and your spouse own the same investments in multiple accounts, a good practice for tax-loss harvesting is to sell the investment in the taxable account then turn off automatic reinvestment and rebalancing in yours and your spouse’s accounts.
Keeping the secondary investment longer than you should. Once you do tax-loss harvesting, it is a good idea to replace it with the original investment, depending on how much you like the original investment, transaction cost, and tax liability. Be very careful when switching back to the original investment because you could trigger a short-term capital gain, which is taxed at ordinary income tax rates. Thus, not only do you lose the tax benefit from tax-loss harvesting, you could be owing more taxes because the short-term capital gain from switching back to the original investment could be higher than the capital loss from tax-loss harvesting. Wow.
When you switch between investments because you did tax-loss harvesting or tax-gain harvesting, you could pay more in taxes because the dividends are not qualified dividends due to the holding period. ”Dividends can be classified either as ordinary or qualified. Whereas ordinary dividends are taxable as ordinary income, qualified dividends that meet certain requirements are taxed at lower capital gain rates.” Source: irs.gov
On page 19 of 76 on the IRS website for qualified dividends. For the holding period, “you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.” Source: irs.gov
You should do tax-loss harvesting throughout the year and not just in December. Let’s look at the S&P 500 index from January 1, 2019, to December 31, 2019, on Yahoo Finance. If you only do tax-loss harvesting at the end of the year, you would have missed out on a couple of tax-loss harvesting opportunities, and you did not capture the lowest point in 2019.
Capital gains and losses:
With long-term capital gains, you pay the long-term capital gains tax rates. You can do tax-gain harvesting, and we will talk about that later.
With long-term capital losses, the losses can offset long-term capital gains, short-term capital gains, $3,000 off of your ordinary income, and then remaining losses carry forward to next year.
With short-term capital gains, you pay ordinary income tax rates. You can do short-term tax-gain harvesting with the investment gain and still be in the 0% income tax bracket if it applies to you. If not, you might want to hold the investment for at least more than a year to get long-term capital gains tax treatment.
With short-term capital losses, the losses offset short-term capital gains, long-term capital gains, $3,000 off of your ordinary income, then remaining losses carry forward to next year.
Remember, to get long-term capital gains or losses tax treatments, you need to hold the investment for more than a year, which is more than 365 days. If you hold the investment for 365 days or less, it’s considered a short-term capital gain or loss.
Capital gains tax rates are lower than ordinary income tax rates. Selling investments at a loss is a great way to lower your taxable income, and you are not selling out of an investment position because you are replacing it with something very similar.
Strategy on what to do after you did tax-loss harvesting:
Reinvestment of the tax savings. When you do tax-loss harvesting, you are getting the tax savings. You can take the tax savings and invest that money so it can grow and compound over time. For instance, from the previous example, instead of paying the $1,500 in capital gain tax, you offset it with a capital loss. You saved $1,500 by doing tax-loss harvesting. You can transfer $1,500 from your bank account to your brokerage account then invest it. Instead of paying taxes to Uncle Sam, you are shifting that money to your account and deferring the taxes on the gains. There are a couple of strategies you can do to avoid paying taxes on the gain.
When you do tax-loss harvesting, you are decreasing your investment cost basis. The strategy is even more powerful when you know how to avoid paying taxes on investment gains.
Some strategies you could do:
Give the investments to a charity if you are charitably inclined.
Hold onto the investments, then when you are deceased, your beneficiaries will get a step-in basis.
Give the investments to family members that are in a low tax bracket.
Sell the investments and realize the gains when you are in a low tax bracket income year.
Ordinary income tax rates are higher than long-term capital gains tax rates. I really like realizing an investment capital loss and having the capital loss offset ordinary income until the capital loss is exhausted rather than offsetting the capital loss with a capital gain. Once I use up all the capital loss, I can sell the investment to get long-term capital gains tax rates. I want to maximize my tax savings. This is just one strategy, and there are other strategies depending on the other circumstances.
Summary of tax-loss harvesting:
You are deferring taxes with tax-loss harvesting because you are decreasing your investment cost basis. We don't know what the tax rate will be in the future, but tax savings today is better than tax savings in the future because if you are in a low tax bracket in retirement, you could potentially pay no capital gain tax. This is a really good transition to talk about tax-gain harvesting.
Tax-Gain Harvesting
What is tax-gain harvesting?
Tax-gain harvesting is selling an investment that has increased in value, then buying the same or similar investment to replace it. The goal is to pay low to no taxes on the investment gain in the year you realized the investment gain.
Understanding of capital gains:
Short-term capital gains are taxed as ordinary income tax rates. Long-term capital gains are taxed at long-term capital gains tax rates. Depending on the investor's taxable income, long-term capital gains are taxed at 0%, 15%, or 20% tax rates.
My favorite tax guide is from the CFP Board. According to the CFP Board 2020 tax tables, for single filers, taxable income between $0 to $40,000 is taxed at 0% long-term capital gains tax rate.
For married filing jointly filers, taxable income between $0 to $80,000 is taxed at 0% long-term capital gains tax rate.
Your taxable income can be more than $80,000 because we are not taking the itemized deduction or the standard deduction into consideration. A single filer can add $12,400 which is the standard deduction for a single filer to the $40,000 which total $52,400 and the married filing jointly can add $24,800 which is the standard deduction for married filing jointly to the $80,000 which total $104,800 and still be in the 0% long-term capital gains tax rate. This applies to the Federal tax, and you could pay state taxes depending on your state and income.
How do we do tax-gain harvesting in practice?
In 2020, you invested $10,000 in a brokerage account. The $10,000 is your investment cost basis. In 2022, the value of the account is $14,000. You sold all of your investments and realized $4,000 in long-term capital gain. Now the $14,000 is sitting in cash in your brokerage account. You take that $14,000 and invest it in the same investment. Your new cost basis for the investment is now $14,000.
If you earned $40,000 from working in 2022, your federal tax liability would be the same whether you sold the investment or not. You might be subject to state tax. You sold the investment because you are a savvy investor, and you want to increase your investment cost basis.
The benefit is to have a lower capital gain in the future when you sell your investment, and it’s easier to do tax-loss harvesting because your investment cost basis has increased.
Example via TurboTax:
Let’s walk through the example in Turbotax.
↪You are single.
↪You are head of household.
↪You are 30 years old.
↪Your taxable wage is $40,000.
↪What were your 2019 federal withholdings? $0.
↪Any 2019 State withholdings? $0.
↪You see, the estimated amount owed is $2,324.
↪Have an investment.
↪Short-term gains/losses? $0
↪Long-term gains/losses? $4,000
↪You see, the estimated amount owed is still $2,324.
https://turbotax.intuit.com/tax-tools/calculators/taxcaster
The benefits of tax-gain harvesting are:
Potentially pay no taxes now and in the future if you are in the 0% long-term capital gain tax bracket. You can sell your investments to realize the long-term capital gain and get a 0% tax on the investments. Although the capital gain increases your adjusted gross income (AGI), your tax liability stays the same as long as you are under the adjusted gross income limit threshold.
Potentially pay no taxes in the future or at least pay less in taxes. Whenever you do tax-gain harvesting, you are increasing your investment cost basis. This decreases your future net gains and lowers your tax liability because your net gain (increased cost basis - sold price) will be lower.
Tax-gain harvesting increases the probability of doing tax loss-harvesting because the investment cost basis has increased.
Tax-Gain Harvesting Best Practice:
If I am under the income limit threshold and can realize a long-term capital gain, I would sell the investment and realize the long-term capital gain to increase the investment cost basis.
It’s also good to do tax-gain harvesting when you are temporarily in a low tax bracket because you just got laid-off, taking unpaid time off, working fewer hours, or transitioning to a new job.
You expect your future tax liability will be higher than today; therefore, you would rather pay the taxes now than in the future. Some investors refer to this as tax bracket arbitrage, which is restructuring your transactions and accounts in a way that is the most advantageous to you so you can pay the least amount of tax.
If you are going to do tax-gain harvesting, pick the ones that have the highest cost basis first because you can sell it in the future, and have less tax liability, it’s easier to do tax bracket management and tax-loss harvesting.
The disadvantages of tax-gain harvesting are:
Your adjusted gross income will increase, and you might have to pay taxes and be phased out on certain tax deductions and tax credits if you are over the adjusted gross income limit.
You might have to pay state income tax, although you pay 0% at the federal level.
Opportunity cost. If you are subject to state income tax, instead of paying the state tax, you could invest that money.
You could increase your alternative minimum tax liability if you are subject to the alternative minimum tax.
You might be subject to the net investment income tax of 3.8% when you reach the annual threshold limits. For 2019, it's $250,000 for married filing jointly and $200,000 for a single filer. Source: irs.gov
Resetting the holding period. When you do tax-gain harvesting, you are selling an investment then buying an investment. The holding period starts again when you buy a new investment.
That’s why it’s good to talk to a professional before making an informed decision because tax law changes, and there could be rules and exceptions you never heard of before.
Other information we should know related to tax-gain harvesting.
Tax-gain harvesting works in taxable accounts, and investments should be long-term, which means the holding period has to be more than 365 days.
You don't have to worry about the wash sale rules with tax-gain harvesting because wash sale rules only apply to losses.
It’s good to do tax-gain harvesting in the middle to last week of December, so you know how much your taxable income is for the year. With tax-gain harvesting, you can sell the investment then buy the same investment again once the cash is settled because the wash sale rules do not apply to gains.
Instead of doing tax-gain harvesting, maybe you should do Roth conversions.
Why?
Roth accounts have tax-deferral benefits.
Qualified distributions are tax-free in Roth accounts.
Your beneficiaries receive a step-in-basis on the investments in the brokerage accounts when you deceased.
Other information we should know related to tax harvesting
Tax harvesting (tax-loss harvesting and tax-gain harvesting) does not work on tax-advantaged accounts, such as 401(k)s, 403(b)s, 457(b)s, tax-sheltered annuities (TSA), Roth 401(k)s, Roth IRAs, Health Savings Accounts (HSAs), 529 Plans, Coverdell Education Savings Accounts (ESAs).
Tax-loss harvesting is not suitable for investors who are in a low tax bracket and don't have to pay tax because if they don't have to pay taxes, why would they want to do tax-loss harvesting and decrease their investment cost basis. Later on, when they sell the investment, they will have a bigger gain and could subject them to paying taxes.
What is the deadline for tax-loss harvesting and tax-gain harvesting? By the end of the year, which is December 31st.
Some financial services firms and robo-advisors do tax-loss harvesting, but they don't do tax-gain harvesting and integrating all of your accounts and your spouse’s accounts so they can all work together. Make sure you ask your advisors or the platform you use on how they are managing your money.
Tax drag. Tax drag is when you are decreasing your after-tax return due to taxes. If you can mitigate taxes, you can increase your after-tax return. Of course, you should not make investment decisions based on tax implications, but you should take taxes into consideration.
Best practice:
You want to pick specific investments to do tax-loss and tax-gain harvesting to get the maximum tax benefits. It's not doing average cost, FIFO (first-in, first-out), or LIFO (last-in, first-out).
Whenever you buy and sell investments, you have to take into consideration the transaction costs, such as the trading fees and bid/ask spread.
Tax-loss harvesting and tax-gain harvesting are good to implement when you can save a couple of thousand dollars. If not, I don't think it's worth the time because time is too valuable. One of the things I learned in life is to do what you are really good at or enjoy doing and outsource the rest to an expert.
Tax harvesting should be integrated with other financial planning strategies, such as asset location, asset classes diversification, accounts diversification, tax-efficient rebalancing, tax bracket management, estate transfer strategies, and many others.
Let’s review the materials by looking at 4 scenarios from worst to best
You did tax harvesting the wrong way and realized a short-term capital gain of $1,000. The $1,000 is taxed at your highest tax rate, and it’s about 50% for high-income earners. Therefore, you paid $500 in taxes.
You are in a high-income tax bracket. You did tax-gain harvesting, realized a long-term capital gain, and it’s taxed at 20% long-term capital gain tax rate. $1,000 X 20% = $200 to taxes.
You are in a low-income tax bracket. You did tax-gain harvesting, realized a long-term capital gain, and it’s taxed at 0% long-term capital gain tax rate. $1,000 X 0% = $0 to taxes.
You did tax-loss harvesting, and the $1,000 loss decreases your taxable income at the highest rate, which is about 50%. Thus, you saved $500. You might say, Tan, you are saving $500 now, but you are going to pay more taxes in the future because you decrease your cost basis. This is the best scenario on the spectrum. If you give the investment to a qualified charity or to your heirs, you saved the $500, and the $500 will never be tax.
Tax harvesting summary:
With tax harvesting, it comes down to 4 options, should you do tax-loss harvesting, should you do tax-loss harvesting, and tax-gain harvesting, should you do tax-gain harvesting, and should you do anything at all?
The benefits of tax harvesting will depend on the individual investor's circumstances because everyone's finances are different and how they execute the strategies can make a big difference.
Tax harvesting is a tax management technique to enhance an investment after-tax return.
Tax-loss harvesting decreases an investor's adjusted gross income (AGI) and decreases the investment cost basis.
Tax-gain harvesting increases an investor's adjusted gross income (AGI) and increases the investment cost basis.
Tax-gain harvesting is really good for investors and retirees who have different types of accounts, such as 401(k), Roth IRA, and brokerage account, so they can control their taxable income and be under the income threshold to get 0% long-term capital gain tax rate.
You want to do tax harvesting at the right time to get the maximum after-tax returns. It’s an advanced technique, and you should talk to a professional to see how you can incorporate it into your investment strategies.
You want to know what your after-tax return is. Your after-tax return is the return you see when you log into your account minus the taxes you need to pay to convert the investment into cash.
Let us know what your tax management strategies to improve your net after-tax returns are.
Thank you for reading and watching. This is Tan, your trusted advisor.
Additional Resources
Are we carrying forward any capital losses from previous tax years that we haven't used yet? If we are, we can use these losses to balance out capital gains or deduct up to $3,000 from our regular income, especially if we don't have any capital gains. It's important to know that while we can carry these losses forward indefinitely on a federal level, some states might not allow this at all.