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.
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I was just reading an article about tax loss harvesting and “getting around” wash sale rules (basically how the rich rotate through different share classes of a company, or ETF’s sold by different companies that pretty much hold the same equities). My thought was that you could sell getting the loss, while buying an in the money call with a strike date more than 30 days in the future? Viable? Ok with the IRS? I don’t know, and would appreciate comments from those that do.
As I understand it, if you sold IBM and replicated the exposure with IBM options, that would count as a wash sale. But if the options weren’t on the same stock or index that you just sold, you should be okay.
Owning actual stocks/ETFs inside of taxable accounts seems to be key. Owning those pesky mutual funds indeed kick off capital gains treatment even when the fund itself losses value. You are right to remove “funds” from your taxable account. Always look at the tax impact in the funds by which you invest. Placing mutual funds inside of IRAs “may” be more efficient.
I recently read a study from JP Morgan where they looked back at the Russell 3000 from 1980. They found that 40% of the stocks in the fund lost 70% of their value and never recovered while 50% of the funds lost 50% and never recovered. 7% of the Russell 3000 accounted for 2 standard deviations of outperformance and made up the majority of the return. So ETFs performed well.
Synopsis, owning the etf actually performed. seems like picking stocks or actively managed funds tend to underperform their index over time. It’s true that some outperform, however, the cost you incur overtime basically brings you back to at or near the index return. Maybe Bogle has it right. Who knows!
Great piece by the way. Always learning from others mistakes or others triumphs is the reason why Humble Dollar is a great place to read about “real” financial implications in contrast to a world of academia.
Glad you found the article helpful. Index funds, whether traditional or ETF, and some of our existing individual stock holdings is where our taxable accounts are headed. Thanks for reading and commenting.
I’m not likely to go to that much trouble for $3,000, that’s just not a material sum of cash. But I applaud those who enjoy tinkering with investments to maximize return. I’m just not one of them and probably would make enough mistakes to end up losing more than I saved.
It’s certainly not a must do, more of a tinkering to maximize as you call it. And yes there’s certainly work involved and opportunity for error.
That said, this will not only save taxes in the current year, but also allow me to make the portfolio better without creating taxes in the process of doing so, and that should “pay” us for a long time.
Thanks for reading and commenting.
It could theoretically be worth much more than $3000, of course. Even millions, hundreds of millions, or billions, depending on a person’s portfolio. There was a ProPublica story just yesterday about how Steve Ballmer generated tax losses totaling $579 million (thereby saving himself around $138 million in taxes) employing a similar strategy.
Thanks for your article Michael.
Wash sale harvesting rules do create traps where the tax loss is postponed when the purchase actions you describe occur. I agree with your article with one caveat.
You say in the article “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.” My understanding of the wash sale rules is that only the number of shares replaced in the 61 day window of the date of the loss sale are impacted.
From IRS Pub 550 – If the number of shares of substantially identical stock or securities you buy within 30 days before or after the sale is either more or less than the number of shares you sold, you must determine the particular shares to which the wash sale rules apply. You do this by matching the shares bought with an equal number of the shares sold. Match the shares bought in the same order that you bought them, beginning with the first shares bought. The shares or securities so matched are subject to the wash sale rules.
IRS Pub 550 goes on with some partial wash sale examples.
My experience for investors who have covered wash sales within the same taxable broker account the broker 1099-B usually gets the tax reporting correct. I like your comment about turning off dividend reinvestment if you are planning to harvest a tax loss to help keep the tax reporting as simple as possible.
Best, Bill
Thanks Bill. So I may have made two mistakes – breaking the wash sale rule, and then misunderstanding that my whole sale was a wash when apparently only a small part may have been 😉 I’ll check out IRS Pub 550.
Bill, thank you for clarifying that, in the case of a dividend reinvestment, only the amount of loss equal to the amount of the dividend is disallowed, rather than the entire amount sold at a loss.
The language on this that you see online can really be confusing. For example, Schwab says in one article:
It’s also possible to trigger a wash sale inadvertently. The most common way to do so is by selling a portion of a dividend-paying security within 30 days of a dividend distribution date. If dividends are set to be reinvested, even the smallest reinvestment will trigger a wash sale and disallow your losses.
That seems to imply that the entire loss is disallowed. But in another Schwab article they say:
Dividends can trigger a wash sale if you reinvest them within a wash-sale period.
Example.
You sell 50 shares of ABC at a loss on October 3. On October 16, you reinvest a dividend from ABC worth about 1.25 shares. That dividend counts as a buy, which means your trade on October 3 is a wash sale. A portion of the loss from October 3 (worth 1.25 shares) is disallowed (or deferred). Additionally, the cost basis is adjusted and the holding period is changed.
Thanks Andrew for the additional info from Schwab, which caused me to look back at Fidelity. Their explanation of how it works is at the link below, under the last section, “What is the wash-sale penalty?”
Perhaps more useful than the article (certainly clearer), on the 1099-B from that year, Fidelity identified as wash sales only the number of shares purchased inside the window, and then also applied the disallowed portion of the loss to increase the cost basis of the shares we continued to hold.
Thank you both for the comments! Learned something today 🙂
https://www.fidelity.com/learning-center/personal-finance/wash-sales-rules-tax
Michael, there really is a bunch of confusing language on this all over the web. The Schwab article wasn’t the only one I came across.
Glad to know the penalty for those inadvertent dividend reinvestment “buys” isn’t quite so draconian.
Indeed there is Andrew. Me too.
I don’t fault the author for tax loss harvesting. Seems to make sense for him (I especially like the idea of rotating out of active into passive). Although I hate taxes as much or more than anyone, I don’t tax loss harvest. I haven’t felt compelled to sacrifice the convenience and simplicity of dollar cost averaging every month into my brokerage account and reinvesting the dividends. I just set it and forget it and build wealth. Maybe one day I will feel the need to try it though.
No reason you can’t harvest losses when they present themselves as you dollar cost average. Then again, certainly nothing wrong with just doing DCA and ignoring unrealized losses. Worked for me for a long time as well.
Michael, I learned some new strategies about tax loss harvesting. Thanks for the informative article!
Glad it was helpful Olin, thank you!
Everyone complains about the complexity of tax rules which get more difficult to understand with every tax code revision. It seems to be impossible to ever simplify the financial relationship between government and the private sector. I think the complexity motivates those who are able to negotiate through the system to their advantage to lobby against simplification. After all, why would a person or a company that is able to use tax loss harvesting, or any number of other rules, to improve their own finances want to change the system in a way that could eliminate their advantage?
I certainly would prefer simpler. But meanwhile, the tax code is what it is, so I’ll do the best I can, including if it involves some work.
Can’t say I ever fully grasped the net value of offsetting gains with losses. Seems like it’s a wash- unless there was no choice but to sell.
Curious on the move selling municipal bonds and moving money within a 401k to stable value. Earnings on the stable value are taxed as ordinary income while interest on municipal bonds is tax free. I have several municipal bond funds, but the goal is income and given it’s still reinvested if the bonds go down in value so much the better.
In my particular case, we’re able to keep our taxable income much lower now than when we were working, so there’s no real tax benefit to holding munis. Their tax equivalent yield for us is much lower than that of even a taxable short term bond fund, nevermind the higher rates of the stable value fund.
I see Jonathan already addressed the other taxation point.
No, it isn’t a wash. By offsetting losses against gains, you avoid a tax bill. Why wouldn’t you want to do that?
Everything coming out of a traditional 401(k) is going to be taxed as ordinary income anyway. Thus, why wouldn’t you own a fund that kicks off ordinary income? At least with the 401(k) you can defer the tax bill until you make withdrawals.
I once had losses because a partnership closed, the offset was valuable. But is it wise to create losses just to offset gains? I guess so, many do it.
401k defers taxes, but munis eliminate them.
Munis eliminate federal taxes, they only eliminate state taxes if they were issued by the state in which you pay tax (if your state has an income tax). I was happy to take a tax loss this year, it will benefit me for a couple more years as well.
I still am carrying forward losses from the dot-com era. The call center in India that me and a couple of other guys dreamed up was not successful, we had to sell out a loss. I was only a small player, but we invested a total of $5 million – we had about 80 employees in an office in Chennai. It was a New Jersey C corp that owned a subsidiary Indian company. Unwinding the US corporate structure took a while.
There was a article in the Journal of Accountancy a number of years ago regarding planning related to capital loss carry-forwards to avoid losing their tax benefit if you will not use them before your death.
It may be worth a read for you. https://www.journalofaccountancy.com/issues/2017/jul/tax-planning-opportunities-final-tax-return.html
Best, Bill
Wow.
Well, it was the dot-com era, everybody wanted to start a company, go public, and get rich. If we had been successful, I might have turned a $100K investment into $3, $5, or even $10 million. Sure, It was a gamble, but things didn’t work out. If you’re going to be an angel investor, you have to be prepared to take a big loss.