The idea behind tax loss harvesting

[rickmerrill]

I've done some reading and some thinking but I can' get my mind around tax loss harvesting.

Sure, if you had a looser and didn't think it would ever recover you could recover some of the loss against your taxes and maybe offset some gains as well. But generally we don't want to lock in losses so my instinct would be to just wait for a recovery. I know I'm missing the nuances of this but I just don't get it. Please keep you answers simple, remember your audience!

[Default User BR]

Sure, if you had a looser and didn't think it would ever recover you could recover some of the loss against your taxes and maybe offset some gains as well. But generally we don't want to lock in losses so my instinct would be to just wait for a recovery. I know I'm missing the nuances of this but I just don't get it. Please keep you answers simple, remember your audience!

There are two basic ways people perform TLH:

1. Sell the losing fund, collect the loss. Wait 30 days, buy it back. There is a chance that the fund could go up during that time.

2. Buy replacement fund or funds that will give you a similar investment allocation without being a wash sale. Example, sell S&P 500 and buy Large Cap. Choose something that will be acceptable to hold for a long time. I broke VEU into VEA + VWO, then later broke VEA into VPL + VGK, for TLH purposes.


Brian

[jsl11]

When you sell a fund at a loss, you want to buy another similar (but different) fund right away. In this manner you do not "lock in" your loss. If you want to buy back the same fund, you have to wait 31 days to avoid "wash sale" rules.

Jeff

[rickmerrill]

Sure, if you had a looser and didn't think it would ever recover you could recover some of the loss against your taxes and maybe offset some gains as well. But generally we don't want to lock in losses so my instinct would be to just wait for a recovery. I know I'm missing the nuances of this but I just don't get it. Please keep you answers simple, remember your audience!

There are two basic ways people perform TLH:

1. Sell the losing fund, collect the loss. Wait 30 days, buy it back. There is a chance that the fund could go up during that time.

2. Buy replacement fund or funds that will give you a similar investment allocation without being a wash sale. Example, sell S&P 500 and buy Large Cap. Choose something that will be acceptable to hold for a long time. I broke VEU into VEA + VWO, then later broke VEA into VPL + VGK, for TLH purposes.
Brian

Thanks for responding Brian.

1. Still not there. I think I get the how part but i don't get the why. So say I sell and loose 1000, wait, buy it back. Is this to reset my basis? I'm out 1k, now what? If it goes up is that bad?

2. Understand wash sale rules, I think. Yeah, I'm still lost here. I'm trying to find the advantage.

[rickmerrill]

When you sell a fund at a loss, you want to buy another similar (but different) fund right away. In this manner you do not "lock in" your loss. If you want to buy back the same fund, you have to wait 31 days to avoid "wash sale" rules.

Jeff

Thanks Jeff.

So I had 20k, sell for 10k, buy a similar fund with the 10k - don't see how I did not Lock in the loss. Sorry, I'm slow!

[rr2]

Take the following simple example. Ordinary income marginal tax bracket is 30% and long term capital gains is taxed at 15%. Also no other transactions are made besides those shown below. Furthermore Fund A and Fund B have identical NAVs and track each other.

June 1, 2011: buy share of Fund A at $10 a share

July 15, 2011: price of Fund A drops to $8. Sell it and buy similar but different Fund B which sells at the same price. However you get to deduct $2 at ordinary income I.e. you get back $0.60. Instead of buying 1 share of Fund B you buy $8.6/$8 = 1.075 shares.

August 17th, 2012: price of Fund B is at $15 a share. Now sell.
Tax paid on sale = (15*1.075-8.6)*0.15 = $1.13
Net profit from transaction = 15*1.075-10.00-1.13= $5.00

Assume no TLH, then after sale of Fund A on August 17th, 2012.
Tax paid on sale = 5*.15 = $0.75
Net profit = $4.25

After TLH, you come out ahead.

[rickmerrill]

By Jove rr2, I think I've got it! Thank you very much!

[livesoft]

A couple more things about tax-loss harvesting:

It helps one get over the fear of selling losers and the behavorial finance trap of loss aversion. After one has sold losers many times, then one is so used to it, that one starts to enjoy selling positions that have losses. This is way more important than one might think because the loss aversion trap prevents one from becoming a better investor.

TLH also is like a time machine where one moves in time from a high tax rate to a low tax rate. The time machine really can save a ton of taxes in the right situations. I have explained this many times, but folks still just don't get it. Here is a specific example: In 2012, we ended up paying taxes at the 45% marginal income tax rate. The $3,000 capital loss from TLHing that I entered on my tax return, thus saved me $1,350 in real money. Later on when I retire, I make up that $3,000 by realizing a long-term capital gain, but the tax rate I will pay on that gain will be 0%. I saved myself $1,350. Or where else can I get a 45% return on my money?

Of course, this does not work in a tax-advantaged account. I must admit that I still have loss aversion in my tax-advantaged accounts. I really hate to have my Roth IRA drop in value.

[Keep It Simple]

I have explained this many times, but folks still just don't get it. Here is a specific example: In 2012, we ended up paying taxes at the 45% marginal income tax rate. The $3,000 capital loss from TLHing that I entered on my tax return, thus saved me $1,350 in real money. Later on when I retire, I make up that $3,000 by realizing a long-term capital gain, but the tax rate I will pay on that gain will be 0%. I saved myself $1,350. Or where else can I get a 45% return on my money?

Well stated, Livesoft.

I am also amazed that tax loss harvesting is not performed by 100% of the bogleheads on this forum(it should be performed by all investors). I do understand that it can be confusing to some, but with Vanguard now doing most of the work for you via the new covered shares regulations, TLH has become a very simple process for all shares purchased after 1/1/2012.

I believe we need to promote TLH more as I don't think most people understand just how much they are missing out on by not taking advantage of this.

K.I.S.

[Call_Me_Op]

Later on when I retire, I make up that $3,000 by realizing a long-term capital gain, but the tax rate I will pay on that gain will be 0%.

I assume that is because you anticipate a very low income in retirement [dividends, interest, and capital gains]?

[livesoft]

I wouldn't call a six-figure income "very low". However, I do expect the tax law to maintain inflation-adjusted exemptions, allowances, and deductions and lower tax rates for long-term capital gains and qualified dividends. I do not intend to have more than $10 in interest income annually (same as now) because interest income is taxed at a high rate.

[rkhusky]

I wish I had been aware of the mechanics behind TLH in 2008 and 2009.

[kaneohe]

an more conventional example of TLH w/ simpler math:
1) buy 10K of A which decreases in value to 7K
2) sell 7K A and buy 7K B (similar but different) which performs the same as A (assumed)
3) hold 7K of B for N yrs when it recovers to 10K value at which time you sell B
on the surface, it appears that you broke even which would have been the same if you had simply held A

However the following tax consequences make a difference:
2) 3K capital loss; assuming no capital gains, loss may be used against ordinary income; in 30% bracket , you save $900
3) 3K capital gain; assuming 15% capital gains rate, you pay $450
for a net savings of $450. In addition you have the use of that initial $900 savings for N yrs when it presumably earns you more.

The TLH helped by
a) shifting 15% capital gains rate for possibly a higher rate ordinary income loss
b) time value of money invested
If your TLH had been larger than 3K, your annual loss (excess over gains) would have been restricted to 3K/yr but you could have repeated using the loss over a
number of years.

If instead of investing the tax savings from TLH, you spend it, it won't be there to pay the tax in step 3) and you may not benefit from TLH.

[BrandonBogle]

A couple more things about tax-loss harvesting:

It helps one get over the fear of selling losers and the behavorial finance trap of loss aversion. After one has sold losers many times, then one is so used to it, that one starts to enjoy selling positions that have losses. This is way more important than one might think because the loss aversion trap prevents one from becoming a better investor.

TLH also is like a time machine where one moves in time from a high tax rate to a low tax rate. The time machine really can save a ton of taxes in the right situations. I have explained this many times, but folks still just don't get it. Here is a specific example: In 2012, we ended up paying taxes at the 45% marginal income tax rate. The $3,000 capital loss from TLHing that I entered on my tax return, thus saved me $1,350 in real money. Later on when I retire, I make up that $3,000 by realizing a long-term capital gain, but the tax rate I will pay on that gain will be 0%. I saved myself $1,350. Or where else can I get a 45% return on my money?

Of course, this does not work in a tax-advantaged account. I must admit that I still have loss aversion in my tax-advantaged accounts. I really hate to have my Roth IRA drop in value.

I have the exact same behavioral bias. I am getting better and have been pruning my IRA holdings, but it's been much easier to sell off my losers in the taxable account. In particular, to rebalance, I needed to sell some domestic equity and buy some bonds funds. I was originally going to do that completely in my 401k, but instead I sold my losers in taxable and changed my new contributions to buy in 401k. Already managed to finish that one off!

[Dandy]

It's a good idea to understand it. You can stick with losers that never come back and meanwhile be paying tax on current gains. Also, as noted buying back the loser after 30 days you can still wait for a turnaround and get the tax benefit to boot.

[rickmerrill]

Thanks everyone for responding, I'm off to re-read some of livesoft's time machine posts...