WE TRIMMED THE TAXES we owed on investment gains in 2021 by using losses we’d realized during 2020’s stock market swoon. Now, 2022’s market decline has allowed us to repeat this process, once again offsetting capital gains with tax losses that we’d earlier harvested.
My wife and I haven’t just saved on taxes, however. The sales have also allowed us to reposition our taxable portfolio away from active management and toward more of an indexing bent. Along the way, we sidestepped one mistake but made two others—mistakes you’ll want to avoid if you decide to make similar trades.
Here are some of the investment moves we’ve made over the past year:
Regarding this last move, you might wonder why we swapped index funds back and forth. We did so purely to harvest losses that we could then use to offset later gains. While the index funds we’re switching between are not identical—that would disallow the tax loss—they’re similar enough for our investment purposes.
At this stage, we’re happy to own these index funds no matter what the market does. If the market continues higher, great. If it drops, we may trade between these funds again—and harvest new tax losses.
Our losses allowed us to offset $3,000 in ordinary income last year. That was a bonus because our marginal tax rate—the rate we pay on our last dollar of income—is higher than the 15% rate we pay on long-term capital gains, and thus it’s especially attractive to offset losses against ordinary income rather than capital gains. With more tax losses from 2022, we have the same tax-saving opportunity this year.
Other harvested losses allowed us to sell one actively managed fund and reduce our position in another. Both of these sales created some gains, but we could offset them with recently harvested tax losses from one of our index funds.
While all these trades have worked as intended, this kind of exercise isn’t foolproof. If you choose to realize gains and losses, here are three things to watch out for.
Violating the wash-sale rule. A few years ago, I broke the rule and wasted a small loss. You may be wondering how I could possibly mess this up. You sell at a loss and wait 30 days before buying the same or substantially identical security again. Easy, right?
Wrong. The issue is that the 30 days work in both directions, before and after the sale, and includes buying any shares through the automatic reinvestment of dividends. So, if you had even the tiniest dividend reinvested within 30 days of selling at a loss, that creates a wash sale and the entire transaction is not tax-deductible.
To avoid this, check for dividends from the stock or fund before you sell. To make it even simpler and foolproof, have your dividends paid in cash to the money-market fund connected to your brokerage account.
Also, know that you must do this for every account in which you hold the security, not just the one where you’re selling. If you sell a stock or fund in one account, and the tiniest dividend is reinvested in the same security in another account, that’s still a wash-sale rule violation.
Buying the dividend. This happens when you purchase a stock or fund just before the ex-dividend date. Buyers of shares before that date will receive the next dividend payment. In my case, I harvested a loss in one fund and bought its replacement just in time to get paid a dividend.
Since the share price drops when a dividend is paid, isn’t this all even? Yes—except we owed taxes on the dividend paid. Had I remembered to check, I’d have waited a few more days to realize the loss and buy the new fund.
Avoiding a taxable dividend payment like this is very simple. You just need to remember to do your homework. Check the ex-dividend date of the security you’re about to buy and, if a dividend is near, consider waiting until after the ex-dividend date, especially if it’s a large amount of money.
Breaking tax thresholds. This hasn’t happened to us, but realizing taxable gains could be costly in unexpected ways. Enough harvested gains might push you into a higher marginal tax bracket or trigger the net investment income tax, alternative minimum tax or Medicare’s income-related monthly adjustment amount, otherwise known as IRMAA. To avoid all these, keep an eye on how close you are to crossing the thresholds involved.
When I wrote about using capital losses in 2021, I was in my last few months before retirement. That summer, I was already thinking about the details of what I would sell and when, and how I’d keep track of dividends and capital gains distributions toward the end of the year. Now that I’m fully retired, I somehow seem to have less time to spend on these details.
This process does require time—and thought. It takes me a few hours to identify losses, find appropriate investments to take their place and keep track of our income so we don’t inadvertently go over certain tax thresholds. Some of these hours are required late in the year, toward holiday time, when we often have more fun things to do.
I intended to make some of these moves in the last week of December. No matter, the strategies still work even if the calendar changes. With another few years of harvesting, we’ll have eliminated the actively managed funds in our taxable accounts and realized a chunk of their embedded capital gains without paying taxes.
Our portfolio will be simpler and more tax efficient, too, with fewer annual capital gains distributions. Any loss harvesting will likewise be much simpler, likely limited to exchanging one index fund for a similar one.
Michael Perry is a former career Army officer and external affairs executive for a Fortune 100 company. In addition to personal finance and investing, his interests include reading, traveling, being outdoors, strength training and coaching, and cocktails. Check out his earlier articles.