What's the point of tax loss selling?

Managing taxes can help your bottom line as much as good investment selection. Tax-loss selling, also known as loss harvesting, is an example of a simple strategy that can save taxes for those investing using taxable accounts. Here's an overview of how it works and why it's worth the bother.

Let's start by thinking long term. An investor who plans to own stocks and bonds "forever" in a taxable account knows that they'll face many ups and downs in the future. Stocks in particular can be quite volatile, dropping in value by 5%, 10% or more - much more - on the way to eventual gains. That's the case for both individual stocks and entire equity asset classes like US Large-cap stocks, US Small-cap stocks, Foreign Value stocks, etc. If you plan to invest regularly in a mix of stock asset classes, you know you're going to have some loss holdings along the way. It's inevitable.

During those dips, you can sit tight and do nothing and in fact, that can be a perfectly acceptable investment strategy. As a tax strategy though, it could be leaving money on the table. The reason is that the US tax system only acknowledges realized gains and losses, meaning gains and losses that resulted after you actually sold an investment (with some exceptions unimportant to this discussion). If one of your investments falls in value $10,000 during a market dip, nothing appears on your income tax return unless you sell the investment during the dip. And if that investment gains $10,000 it's the same - there's nothing on your tax return unless you sell.

Tax-loss selling means selling losing investments in taxable accounts to realize capital losses that can be listed on your federal income tax return. It means selling during the dips. It doesn't mean getting out of stocks because they fell though. The ideal tax-loss sale is immediately followed by the purchase of an investment that will perform as closely as possible to the one sold. It can't be the same investment, because under tax rules that would prevent you from writing off the loss right away. But you do want to replace it; you aren't selling for investment reasons, you're selling for tax reasons.

Let's run through a simple example, someone who started investing in 2007 with $250,000, adding $1,000 per month. They bought a low-cost US-stock index fund as the sole investment. Which one it was isn't too important, as this is just a hypothetical illustration of the concept.

It's a convenient period because US stocks pretty much went down continuously for the next two years, losing nearly half their value, but eventually gained. Look:

Let's start with the investor who did absolutely nothing throughout that dip. Here's how this hypothetical investor's account fell and then grew in value; also shown is the cost basis of the investment, which in this case is the total of all purchases including reinvested dividends:

Looking at the right side of the chart, the "white space" between the light blue shaded area and the "Value" line represents the unrealized capital gains in early 2015. That's the amount you'd pay capital gains taxes on if you sold the fund. Note that in early 2009, during the big dip in US stocks, the value was well below the cost basis. At that time, there was a large unrealized capital loss. It stayed unrealized, because this is the Investor Who Did Nothing. Again, not a bad investing strategy as it turned out, but possibly not the best tax strategy.

Now let's throw in a tax-loss sale in early 2009. I chose this period because conveniently, all the purchases before that point would have shown losses then - it was a "bottom" relative to every prior date since early 2007. A tax loss sale would have been simple: sell the whole thing. The losses at that point, for the fund I chose for this illustration, would have been about $136,100. And in this example we'll have the investor immediately purchase a nearly identical investment that still passes the "wash sale" tax rules, allowing the use of the loss on your federal income tax return without really changing your investment mix. Here's the effect of that sale:

See the outcome? First, the Value curve ends in the same spot. This is hypo-land with an investment whose performance is identical to that of the one sold. In reality it would be slightly different - but chosen carefully, not so different that it would make too much of a difference in end value. There are many highly-correlated US stock index funds out there.

So why bother, if the value is about the same? Because this investor was able to list a $136,100 loss on his or her 2009 federal income tax return - something that Do Nothing wasn't able to do. And that's where things get interesting. Here's what happens with capital losses on your tax return:

  • The full $136,100 loss can be used to offset capital gains on other investments, or from your sales of company stock, or from the sale of your business, or from the sale of your rental property, etc. - any capital gain, really. That's a lot of loss "in the bank" to free up the sale of other things, without paying taxes on those sales. 
  • If any loss remains, up to $3,000 of net capital losses can be used against your other income, such as job income, lowering your Adjusted Gross Income in the process. The value of that depends on your tax bracket and overall tax picture; if your marginal tax rate with phaseouts is 40%, a $3,000 loss saves you $1,200 in taxes.
  • If the above two don't "use up" the $136,100 loss, the rest will carry forward to next year's tax return to be used in a similar manner.
  • The same happens in the year after that, and the year after that, and the year after that, etc. - until the loss is fully used up.

The value, then, depends on your specific tax picture in both the year of the sale and subsequent years. The higher your tax bracket, and the more you have "unavoidable" capital gain income from other sources, the more likely you'll see an immediate benefit. If the loss offsets other long-term capital gains, a typical tax benefit as percentage of the loss total might be 15% federal and (in California) 9.3% state, 24.3% total. If you're subject to the Medicare surcharge on investment income, make that 3.8% higher. If you're high-income, and pay the 20% capital gains rate, add another 5%. If you face phase-outs, AMT, and other shenanigans on your tax return, or you're offsetting short-term capital gains, you might be looking at a tax benefit as high as 45%+. Then again, if your income is low, you might be paying no tax on capital gains - and it's a pointless exercise.

Note one other thing in the graph above: all that additional white space between the cost basis and the value in the tax-loss-sale scenario. A result of tax loss selling is that it leaves you with more unrealized gains later. Whether this exercise all nets out to a benefit depends on what happens down the line.

For clients, tax-loss selling opportunities are something I watch for throughout the year. Not just during bigger market dips, but any time there's enough of a loss, and a readily-available replacement investment. Not all clients benefit from it, so it's important that we stay in touch about your expected income and deductions each year.

 

Clients, call or email if you want to talk about tax-loss selling in your taxable accounts. This article is meant to be general in nature, and should not be considered specific tax or investment advice. Discussion reflects tax laws in effect for tax year 2014, and does not address all possible scenarios. Charts are meant to be illustrative examples, ingoring transaction costs and management fees other than those charged by the fund, and do not represent an actual investor's returns.