A Tax Tip to Fatten Your Bottom Line

Last month I wrote about how I’ve used the Affordable Care Act (ACA) to bridge the gap to Medicare. I pointed out that lowering the adjusted gross income (AGI) I report on my federal tax return is the key to maximizing benefits.

Several readers commented that their AGI is too high to net meaningful ACA subsidies. Among other sources, they cited income from interest, dividends and/or capital gains in taxable accounts as the main culprits.

Whether your goal is to maximize ACA subsidies or not, there are strategies you can use to minimize costly drag on your taxable accounts. These include holding ETFs instead of mutual funds, shunning REITs and selling assets at the long-term capital gains rate.

In today’s post I’ll share another strategy that every investor should know about. It’s called tax-loss harvesting and, used effectively, it can add considerably to your bottom line.

Related: The Benefits and Drawbacks of Taxable Accounts

How Do You Harvest a Capital Loss?

Suppose I sell an ETF that tracks the S&P 500 Index at a loss, and simultaneously repurchase an ETF that tracks the total U.S. stock market. Assume the former is BlackRock’s iShares Core S&P 500 ETF (IVV), and the latter Vanguard’s Total Stock Market ETF (VTI).

Having realized—or harvested—a capital loss on the sale of IVV, I can use it to offset a capital gain, or deduct it from my total income at tax time. In either case, I reduce the amount of tax I owe.

What’s more, by repurchasing VTI at the moment I sell IVV, I put myself right back in the market. If the market recovers, the value of VTI goes back up with it.

To see what I mean, take a look at this chart comparing the performance of IVV and VTI over the last five years.

The high correlation in performance between IVV and VTI represents a significant opportunity; namely, to realize a tax-deductible capital loss when markets are down, and simultaneously be in a position to profit if/when the market recovers.

To make the point a little more concrete, let’s consider a couple of scenarios using IVV and VTI as examples.

Deduct a Capital Loss on IVV

Let’s say I sold IVV, and immediately repurchased VTI, in September 2022, thereby realizing a $10,000 loss on the IVV sale. I could have deducted up to $3,000 of the loss from my total income in 2022, and again in each subsequent year until the remainder of the loss was exhausted.

Note the maximum capital loss deduction allowed by the IRS is $3,000 per year ($1,500 if married, filing separately). Whatever is left can be carried over and deducted from subsequent years’ income, thus reducing taxable income in each of those years.

Offset a Capital Gain on VTI

Alternatively, I could have used the entire loss on the September 2022 IVV sale to offset a capital gain; either from a previous sale made in 2022, or one that I make at any date in the future.

For example, suppose I later sold the VTI I bought in September 2022 at a $12,000 gain. Subtracting the $10,000 IVV loss nets me a taxable gain of just $2,000 in the year I sold VTI.

This assumes I did not claim a $3,000 deduction in 2022, or any year thereafter. If I had, I could only use the remainder of the loss to offset the VTI gain.

A Free Lunch?

While these strategies will reduce my tax liability in the current year, they come at a price down the road.

Sticking with the examples above, suppose that instead of swapping IVV for VTI, I had continued to hold IVV in September 2022; that is, not sold it to harvest a $10,000 loss. In that case, I would have retained the original, higher cost basis on IVV, thereby reducing gains on any of its future sales.

By harvesting a tax loss on IVV, on the other hand, I traded higher taxable gains in the future for tax deductions today.

A Discounted Lunch?

Tax-loss harvesting can still put you on the plus side of the ledger; say if you expect your future income to be lower than what it currently is.

In that case, you can offset higher income today, netting you more bang for your buck. Meanwhile, the bigger, deferred gain will have less impact on your overall tax liability down the road when your income is lower.

Then there are folks who would just prefer to have a single marshmallow today, rather than waiting till tomorrow for two (after all, there may not be a tomorrow). If you are like me in this respect, the immediate benefits of tax-loss harvesting may be all the justification you need.

Caveats

There are a number of caveats to take into account before employing these, or similar, strategies. Perhaps the most notable of these is the wash sale rule.

The Wash Sale Rule

The IRS defines a wash sale as a transaction in which an investor sells a security at a loss, and then repurchases the same or substantially identical security within 30 days before or after the sale.

It’s called a wash sale because the transaction doesn’t change the investor’s position in the asset. After all, the investor is out of the position for just a brief period of time—perhaps as short as a few milliseconds—during which the asset’s price has changed little if at all.

There is nothing wrong with this type of transaction per se. But the IRS gets persnickety if the investor deducts the loss from his income at tax time.

In effect, the loss from a wash sale is on paper only, and the IRS does not like to cede revenue to taxpayer deductions from dubious losses. To prevent investors from gaming the tax code in this way, the IRS created the wash sale rule.

Are IVV and VTI Substantially Identical Securities?

Do the examples above, involving IVV and VTI, constitute violations of the wash sale rule? I would argue no.

IVV tracks companies in the S&P 500 index. VTI tracks the total U.S. stock market. To be sure, both ETFs hold stocks in many of the same companies. But the total market fund consists of 3,678 holdings, including thousands of mid- and small-cap companies that the S&P 500 does not. Meanwhile, the S&P 500 index fund holds just the large-cap companies listed on that index.

Moreover, IVV and VTI were created, and are managed, by different companies; BlackRock and Vanguard, respectively. Each company employs different fund managers, and each charges fees that will impact the long-term performance of their funds differently.

By any reasonable interpretation, IVV and VTI are not substantially identical securities.

Nevertheless, it is important to note that harvesting a tax loss in the manner described above, but using the same or substantially identical securities, would run you afoul of the wash sale rule.

Don’t Sit on a Loss

Selling and repurchasing an ETF to capture a loss is not entirely without risk. If the market spikes between sale and repurchase, you may miss out on a substantial portion of the gain.

Because ETFs trade intraday, this risk can be mitigated—in fact effectively eliminated—by repurchasing the new ETF the instant the existing one is sold.

To be extra careful, it wouldn’t hurt to wait for a period of low market volatility to execute a swap.

A Disclaimer

Finally, I am not a professional financial or tax advisor. Nor am I aware of the particulars of your financial situation; particulars that may weigh against your using the strategies gamed out in this post.

Given these caveats, I urge you to do your own research before acting on any of this information. If you are still unsure, then consult a professional financial and/or tax advisor.

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[I’m David Champion. I retired from a career in software development in March 2019, just shy of my 53rd birthday. To position myself for 40+ years of worry-free retirement, I consumed all manner of early-retirement resources. Notable among these was CanIRetireYet, whose newsletters I have received in my inbox every Monday morning for the last ten years. CanIRetireYet is one of exactly two personal finance newsletters I subscribe to. Why? Because of the practical, no-nonsense advice I find here. I attribute my financial success in no small part to what I have learned from Darrow and Chris. In sharing some of my own observations on the early-retirement journey, I aim to maintain the high standard of value readers of CanIRetireYet have come to expect.]

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