What could be more exciting than a blog post about taxes? That is an easy one, the answer is obviously a blog post about how to save on taxes when you are losing money on your investments. It’s just a small way to find a silver lining in a situation of a loss.
Taxes irritate me. I know we have to pay them and I am happy to pay them and support our local municipalities and government workers who help and serve the community. But I am not excited about paying any more taxes than I am supposed to pay.
The reason I wanted to learn about money was that I didn’t think anyone would watch over my money as well as I would, which is the same reason I don’t want to pay anything extra in taxes – I’m not confident it will be managed or spent in a manner that I would agree with. Ok, Tax rant over.
Here recently the market has actually been going back up for a change, so maybe this post isn’t super timely. Maybe we found the bottom of the stock market already or maybe we will have more negative financial news and down markets in the days ahead. You never really know, so it’s best to always be prepared.
There are a few areas of our financial life that we have focused on in order to reduce our taxes. Here are a few of them:
–Contribute to a 401K, and IRA – Not only do we get a tax deduction in some cases, but the money also grows tax-free or tax deferred.
–Invest in Real Estate – which carries a different set of tax rules allowing us to depreciate the property each year. The end result of this is that the majority of income from the rental house will end up being tax-free.
–Strategic about our charitable giving – we have talked about this before LINK, but giving to our local church and local nonprofits is very important to us. We have always prioritized this, even when it didn’t seem to make sense for our budget. Today we try to always give in a tax-efficient manner which includes giving from a Donor Advised Fund and gifting stock that has appreciated in value. This allows us to avoid paying tax on the gain of the stock and we are still able to take a deduction for the full value of the gift.
–Tax Loss Harvesting – Claiming Losses of taxable investments against your ordinary income.
I believe I have written at length about all of the above except for Tax Loss Harvesting. Spoiler alert, if you are like 99% of our readers and you read through all my nerdy crap to find Alison’s comments, you might want to just keep going until the end. Since this might be a little detailed and technical, let’s start off by talking about who tax loss harvesting can help and who it makes sense for.
There is no ability to tax loss harvest unless you have investments in a taxable or a brokerage account. If all of your money is in your 401K or IRA, there is really no ability to do tax loss harvesting or benefit from a Donor Advised Fund. However, as you start to save more outside of just retirement accounts, you should be able to transition to a brokerage account and that is where you can benefit from the tax loss harvesting. A brokerage account is helpful if you are saving money that you will need before the traditional retirement age. This could be money for early retirement or even just additional savings for a house, remodel, or general savings.
The Details of Tax Loss Harvesting
Tax loss harvesting is selling an investment with a loss, and reporting that loss on your taxes to offset other investment gains or your ordinary income. If you don’t have any gains from an investment that year, you can still use up to $3,000 to offset your ordinary income. Anything that is unused is banked for future years. This means you could harvest $30,000 of losses in one year and if you never sold another investment you could claim a $3,000 loss each year for 10 years, saving you tax money each year.
Step 1 – Sell Your investment and buy something else immediately while keeping in mind the Wash Sale Rule (more on this below). This keeps you from sitting in cash and missing the market going back up.
Step 2 – Avoid a Wash Sale – The wash sale is a rule by the IRS that says you can’t buy or sell an investment that you sold and claimed a loss on or an investment that is substantially identical. Basically, if a wash sale happens the loss you thought you were claiming is no longer allowed.
Step 3 – Take credit for the loss come tax time.
A piece of cake, right? Maybe we should break down the pitfalls a little bit more.
Selling and taking credit for the loss is easy. The place people get tripped up is the wash sale and what is considered “substantially Identical”. Basically, the wash sale was designed to keep you from selling an investment to claim a loss and buying it immediately back. They want to make sure the loss is truly a loss before you get a tax deduction for it, Which makes sense.
The easiest way to avoid a wash sale is to sell your investment at a loss and then sit out of the market for 31 days before buying the same investment right back. But the problem here is that the market could increase or decrease substantially in 30 days and you have missed out on that opportunity. This is why the
“substantially identical” piece is important. My recommendation is that when you sell your investment you find a replacement to buy immediately.
If you own an individual stock, there is no worry about the substantially identical definition. As long as you don’t buy the same stock, you are free to buy something else. When it comes to mutual funds you have to be a little more careful. What I do, is look for a mutual fund that tracks a different index. The best example is that if you have a Total Stock Market fund (Which tracks the Dow Industrial Average) a good replacement is an S&P500 Mutual fund. But remember no buying or selling 30 days before or after. This includes all accounts – the brokerage account you are doing this in, your 401K, your spouse’s 401K, etc. This can get pretty complicated. Dividends can also screw this up for you if they are set to auto reinvest. It can ultimately make some of your losses not allowable. The easiest way around this is to turn off dividend reinvesting if you are going to tax loss harvest. Investopedia has some great information on Tax loss harvesting if you are looking for a deeper understanding.
Is anyone still with me? I know you are all longing for a post from Alison that is fun and funny. I’ll try and help you out soon.
How About an Example
Action | Investment | Share Value | Total Value |
Bought 3/29/22 | VTI – Vanguard Total Stock Market | $233.05/Share – 50 shares | $11,652 |
Sell 6/16/22 | VTI – Vanguard Total Stock Market | $183.02/Share – 50 Shares | $9151 |
Buy 6/16/22 | IVV – S&P 500 | $366.99/Share -24.9 | $9151 |
From the chart above you see we bought an investment back in March while the market was high and then by the middle of June it was down over 20%. We sold the investment and immediately bought back in with an investment that wasn’t substantially identical, although it’s pretty similar. We captured a $2501 loss of investment and immediately reinvested it in the market. As of the day, I’m writing this (7/21) that investment in The S&P would have grown from $9151 back to $398.22 a share or $9915. We recouped $764 of our loss already in 35 days, but we still have our $2501 loss.
Example of savings from taxes
If you live in Georgia and are in the 22% federal bracket ($41K -$89K as a single filer, or $83K -$178K as a Married Filing Joint), here is how this loss would impact your taxes.
$2501 to reduce your ordinary income if you don’t have any capital gains from an investment. This would save you roughly $694 in Federal and State Taxes. This isn’t a substantial amount of money, but we are also only talking about an investment of $10,000. What if the investment was $100,000? All of a sudden we are talking about saving $6900 in taxes.
The other thing to be sure you understand is that you didn’t miss out on anything in the market. If you don’t tax loss harvest your investments will continue to go up and down all the same. This just gives you an opportunity to reduce taxes and effectively lower your cost basis in your investments and save taxes today. It’s not a silver bullet. You will still have to pay taxes whenever you sell this new investment if it has a profit. However, hopefully, that will be years in the future and if you are retired you should be in a much lower tax bracket.
That is tax loss harvesting. I hope it makes sense and even if you don’t understand every piece of it, the vital thing to know is that it exists and there are always adjustments you can make to better your situation. The key is to know enough to learn to act on them or to ask for help to act on them.
When the market is melting down and my portfolio all of the sudden is red instead of green, I just focus some efforts on finding a few opportunities to tax loss harvest while I wait for the market to rebound.
Alison Here!
Well. I have zero to add on the subject of tax loss harvesting. I didn’t have a clue this existed until Ricky told me about it. I also didn’t realize you had to pay taxes on your investments either, probably because I didn’t have any until I married Ricky. So, if you are totally clueless, don’t worry- you are not alone.
Tax loss harvesting is a great tool to help lower the amount of taxes you have to pay, but if you are just starting out on your finance journey don’t get distracted with this and just stick to the fundamentals. We want this blog to be full of information for people who have $1000 in a savings account or $1 million in investments and everyone in between.
The bottom line is to stick to your game plan. Like Ricky said in the beginning, you want to start with IRAs and 401Ks. If you are still working on filling these up, do not start investing outside of them just to do something like tax loss harvesting or donor-advised funds. If you don’t stick with your game plan and goals it will take you longer to accomplish them.
We hope this post helped you either lower your taxes or have something to say when you want to sound smart at your next family holiday party or while working out at the gym. Keep in mind we aren’t tax professionals so all of this is advice based on what we do. It is always wise to check current laws and regulations.
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