Tax loss harvesting

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 is a way to improve the after-tax return of your taxable investments.

One advantage of taxable accounts is that you can use losses that inevitably occur in some years to lower your tax bill. This is called tax loss harvesting. There are three benefits.

First, tax losses are effectively an interest-free loan which defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die.

Second, after offsetting realized gains, you can use any remaining tax losses to deduct $3,000 from your ordinary income each year. This can mean an extra $750 or more in your pocket if you are in the 25 percent federal tax bracket.

Third, you can roll over any remaining losses into later years, so that you can defer your capital gains and deduct up to $3,000 from your income, each year until you have used up your losses.

Overview
Suppose that you had invested $10,000 into a mutual fund in a taxable account, but after a steep decline your holdings are now worth only $6,000. Because you plan to continue holding that fund, you might consider ignoring the losses and waiting for the fund to eventually recover.

Instead, using tax loss harvesting, you would sell the fund, and then buy it back 31 days later. In the meantime, you can either hold the cash in a money market fund, or invest it in a similar but not substantially identical fund. This realizes a $4,000 capital loss, but putting you back in your original position 31 days later.

This $4,000 capital loss is valuable in several ways.

Before you pay any capital gains taxes each year, you must use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. Short term losses first offset short term gains and long term losses first offset long term gains. If there are any losses left, short term losses offset remaining long term gains or long term losses offset remaining short term gains. If there are any losses left, you must apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over (in this case, $1,000, which is the $4,000 in losses minus the $3,000 deduction) you must carry forward indefinitely into future years.

Each year, you must first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.

Using tax loss harvesting to offset capital gains does not eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. In this example, you will owe more capital gains taxes in the future because you bought back the fund at a cost basis that is $4,000 lower.

However, because future money is worth less than money today, there is a saying in public finance that "a tax deferred is a tax avoided". Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS.

Also, if you (and your spouse) are still holding the shares when you die, your heirs will receive a stepped-up basis, and you will have had the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely.

Finally, the extra capital gains you owe in the (possibly distant) future will be at the (lower) capital gains rate, while the benefit you receive today of the $3,000 deduction is at your (higher) marginal income tax rate.

How it works
Tax loss harvesting works in several different ways. Some examples are shown below.

Investing a single sum

 * January 2008: You invest $10,000 in Total Stock Market.
 * February 2008: The balance drops to $9,000. You sell it.
 * March 2008: You put $9,000 back into Total Stock Market. (Suppose that the share price is the same as in February, 2008 for simplicity.)
 * February 2009: You do your 2008 tax return. Because you have lost $1,000, you can reduce your ordinary income by $1,000, assuming you do not have any capital gains. If you are in the 25% bracket for example, you reduce your tax liability by $250. So, you invest the saving, $250, in Total Stock Market.

Suppose Total Stock Market keeps growing 8% year for 10 years after February, 2008.


 * January 2018: $10,000, which dropped to $9,000 in 2008, becomes $19,430.32 (= $9,000 * 1.08^10). $250 becomes $499.75 (= 250 * 1.08^9). Both of these combined, you have $19,930.07. You sell all shares and pay 15% tax on long-term capital gains. You end up with:

$9,000+($19,430.32-$9,000)*85%+$250+($499.75-$250)*85% = $18,328.05

What if you did not sell Total Stock Market in February, 2008? Note that you do not get $250 back in your 2008 tax return in 2009, so you end up with:

$10,000+($19,430.32-$10,000)*85% = $18,015.77

Notice the $312.29 difference. This is what you get by investing $250 doing a tax loss harvesting. Obviously, the longer you hold shares you purchased with the $250 refund, the more benefit you get.

In this example, you got two types of benefits; you paid less in total tax, and the tax which you did owe was paid much later. When you deducted the $1,000 loss at a 25% rate, you created an additional $1,000 in capital gains to be taxed when you sold later (2018 in this example), but only at 15%. Essentially, the IRS paid you $100 of free money, and gave you an interest-free loan of another $150 in 2009 to be paid back only when you sold the stock. You benefited both from investing the $100 for its full value, and from the interest-free loan which allowed you to invest the $150 for ten years and pay back only the original $150.

In reality, things are a bit more complicated. In the above example, we completely ignored dividends from Total Stock Market. Also, the share price may change between February 2008 and March 2008.

Using a loss from one tax lot to offset the capital gains from another
Suppose the following:


 * January 2008: You invest $1,000,000 in Total Stock Market.
 * February 2008: You tax loss harvest after losing $100,000.
 * January 2010: You invest additional $50,000 in Total Stock Market.
 * January 2011: You retire. You sell the shares purchased in January 2010, which has grown to $60,000.

In 2011, you have not used up the loss realized in February 2008 as you can only deduct $3,000/year, so you can use a part of the remaining loss to offset the capital gain realized in January 2011.

If $60,000 is enough for your living expenses, you may have little or no taxable income because the gain is offset by the realized loss carryforward, and the return of capital, $50,000, is tax free. If this is the case, you might consider Post-Retirement Roth Conversion to take advantage of the standard/itemized deduction and low tax brackets.

Donating low basis shares to a charity
Suppose the following:


 * January 2008: You invest $10,000 in Total Stock Market.
 * February 2008: You tax loss harvest after losing $1,000.
 * March 2008: You reinvest $9,000 in Total Stock Market.
 * January 2009 and on: You make many purchases of shares of Total Stock Market.
 * January 2020: You donate the shares purchased in March 2008 to a charity.

If you donate the shares purchased in March 2008 to a charity, you do not have to pay tax on the capital gains. That is, you keep the full tax savings in 2008 and never "pay back" the savings to the IRS. See Donating appreciated securities for more details.

Stepped up cost basis upon death
Suppose the following:


 * January 2008: You invest $10,000 in Total Stock Market.
 * February 2008: You tax loss harvest after losing $1,000.
 * March 2008: You reinvest $9,000 in Total Stock Market.
 * January 2009 and on: You make many purchases of shares of Total Stock Market.
 * January 2020: You retire and start withdrawing from your taxable account, highest cost basis first.

Perhaps do not sell shares purchased in your life time, in which case, the shares purchased in March 2008 receive stepped up cost basis upon your death. That is, you keep the full tax savings in 2008 and never "pay back" the savings to the IRS.

What if the tax rates go up in the future?
Some people speculate that the tax rates may go up in the future. Tax loss harvesting still works as long as the increase is reasonable. Specifically, you benefit from tax loss harvesting as long as the tax you pay on the $1,000 extra capital gains ($10,000 - $9,000) in the first example above is less than the after-tax amount that $250 grows to.

Suppose the long-term capital gain tax rate goes up to 30%. Then you would pay $300 on the $1,000 extra capital gains. However, $250 grows to $499.75 with the after-tax amount being $424.83, so you are not losing money yet.

Regulatory

 * Wash sale. If you sell Total Stock Market for a loss, while still holding other shares of the same fund purchased within the past 30 days, or purchase shares of the same fund within 30 days after the sale, that would be called a wash sale, and you cannot claim the losses on your tax return. The definition of a wash sale is a bit more complicated than that. Before you tax loss harvest, be sure to familiarize yourself with the wash sale rule.
 * Qualified dividends. If you hold shares for fewer than 61 days and receive qualified dividends from those shares, you cannot take them as qualified dividends, even though the fund company may state that they are qualified. Receiving dividends that are not qualified may outweigh the benefit of tax loss harvesting.
 * Loss on mutual fund shares held 6 months or less. If you sell shares of a mutual fund at a loss, and you have held those shares for 6 months or less, special rules may alter the loss you claim. First, if those shares produced any tax-exempt interest, your loss is reduced, dollar for dollar, by that interest. Second, if you held those shares while the fund distributed (long term) capital gains, you have to treat this loss as a long term loss up to the dollar amount of the distribution those shares produced. Vanguard (and probably most other brokerages) will not adjust your IRS Form 1099-B, so you will have to correct it yourself by filing Form 8949 and changing the type of capital loss.
 * Most Vanguard Tax Exempt funds (and others like them) avoid this six-month rule because of the way they accrue and pay out interest (dividends).
 * However, ETFs and the [ Tax-Exempt Bond Index Fund] (which is the mutual fund class of an ETF) are subject to the six-month rule, because they declare dividends monthly, not daily. To see whether a fund is exempt from the six-month rule, check its prospectus for "dividends are declared daily and paid monthly". If it says "dividends are declared monthly" (or quarterly), the six-month rule applies.


 * Death of taxpayer. Capital losses cannot be carried over after a taxpayer's death. You deduct them only on the final income tax return filed on the decedent's behalf.

Operational

 * Reinvesting dividends and capital gains. If you automatically reinvest dividends and capital gains, you may accidentally trigger a wash sale. If you plan to tax loss harvest, it is generally safer to take dividends and capital gain distributions in cash.
 * Cost basis accounting. Use Specific identification of shares instead of average cost basis to sell shares with losses.
 * Put volatile investments in your taxable account. For example, an international fund is more volatile because of political and currency risks. This makes it more likely you will be able to tax loss harvest.
 * Commissions and bid/ask spreads. If you are tax loss harvesting ETFs or individual stocks, you may have to pay commissions and bid/ask spreads, and these erode the tax loss harvesting benefits. Compare the amount of tax you save to trading costs, and tax loss harvest only when the trading costs are minimal compared to your tax saving.
 * Mutual funds. You do not face commissions or bid-ask spreads. However, some mutual funds have redemptions fees for a certain period after the purchase. Another problem is that you could try to realize a small loss in a mutual fund position, but the loss may disappear by the time the redemption completes. Consider tax loss harvesting on a sizable loss that is unlikely to disappear in one day.
 * Frequent-trading restrictions. Vanguard does not allow you to sell most funds and buy back into the same fund electronically within 30 days. If you plan to buy the fund back within 31 days, do one of the two transactions by mail.
 * Investment volatility. If you wait 31 days to reinvest you will usually see volatility in the investment. If the price of the investment goes up while you are in cash you lose, but if it goes down you gain. You might expect that over a long period of tax harvesting these volatility effects might wash out (if random) or perhaps, if there is a short term momentum effect, a slight advantage to tax loss harvesting over the long haul. You can however mitigate this if you immediately purchase a similar, but not substantially identical investment. However doing this makes your investing more complicated, especially if you are swapping fractional lots of the original fund.

Should I tax loss harvest before or after a distribution?
The general rule is to sell before and buy after a dividend and capital gains distribution. More important is to buy after the distribution; if you sell Fund A to buy Fund B, you want to wait until after Fund B makes a large distribution, even if you receive a distribution from Fund A.

The reason is that you pay tax on any distribution, but every dollar of distribution reduces the fund's NAV by one dollar, so you get a tax benefit from this dollar as a capital loss (or reduced gain) if you sell. When you are selling Fund A to tax loss harvest, you will always get the capital loss. If you buy Fund B, you do not get any benefit from the capital loss until you sell. Even if you intend to switch back immediately, if Fund B pays a qualified dividend, you need to hold Fund B for 61 days rather than 31 or else the dividend loses its qualified status, and waiting 61 days increases the potential cost of switching back.

You usually want to tax loss harvest before a distribution as long as you need not buy the replacement fund before its distribution, but it depends on the type of distribution.

If the distribution is a capital-gains distribution, then it is exactly canceled by the capital loss, so there is no net tax effect. If the distribution is an ordinary dividend then it has increased taxes at the marginal tax rate, and the capital loss is likely to give less in tax savings. If the distribution is a qualified dividend and the capital loss offsets long-term gains, this is break-even because the qualified dividend and reduced capital gain are taxed at the same rate. If the distribution is a qualified dividend and the capital loss offsets short-term gains or ordinary income, there is a benefit for waiting. And if the distribution is a mostly qualified dividend with foreign tax credit, you may pay tax at less than the long-term gains rate, and should wait for the distribution before harvesting the loss.

When not to harvest losses
When you sell at a loss you will either offset capital gains which would have otherwise been taxed at your capital gains rate or you will offset income (up to $3,000 maximum per year) which would have otherwise been taxed at your marginal income tax rate, or both.

If you offset capital gains that would have otherwise not been taxed at all (because your capital gains tax rate is 0%) then this part of the tax loss harvest may be an outright loss. Here is why:

You can think of tax loss harvesting as a loan from the IRS in the following sense. If you reinvest the funds from the the sale in the same or similar securities (after waiting 31 days if necessary to avoid a wash sale), then the transactions give you a lower basis. Ultimately, if the asset price of that security increases you will pay taxes on capital gains when you sell. As a result, the tax loss harvesting tax benefit may ultimately result in a higher capital gains tax rate in a future year than you might have otherwise faced. So, if tax loss harvesting offsets capital gains that would have been taxed at 0% but your future capital gains rate is not 0% then it has created a loss. Put simply, you get no benefit from offsetting capital gains that are not taxed anyway.

Bottom line: know your tax rates before you tax loss harvest.

What if the stock is worthless?
If a company fails, the IRS imposes different rules.

Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became completely worthless during the tax year are treated as though they were sold on the last day of the tax year. This affects whether your capital loss is long term or short term.

Report worthless securities on IRS Form 8949, Part I or Part II, whichever applies. You may need to file an amended return to report a stock which became worthless in a prior year.

Substitute funds
Below is a list of possible substitute ETFs and mutual funds for a given asset class which track similar, but not identical, indices as the commonly-used Vanguard fund.