Tax-loss harvesting
Given the recent market turmoil, don’t forget to sell off securities that are below their cost basis in order to get the tax benefits. I put in a good chunk of change into a Vanguard stock fund just before the market went to pot. I liquidated the Vanguard fund today. Once I get the final capital loss number on Monday, I’ll sell a corresponding amount of GSG at a capital gain that is exactly offset by the Vanguard capital loss.
i’m not sure if i understand. if you need cash liquidity now, or you want to re-balance while minimizing taxes, then this makes sense. but if you’re investing for the long-run (which i assume is what we’re mostly doing) what is the benefit?
Suppose I invest $100 in GSG, and it grows to $150 ten years from now. If I sell GSG at $150 ten years from now, then the government taxes me on the full $50 capital gain.
Now suppose five years into my GSG investment, GSG has grown to $125. I have another investment in which I’ve experienced a $25 capital loss. So I sell that loser investment and also liquidate my GSG holdings. I’ve now locked in that $25 GSG gain without any taxes on it. I re-buy GSG 30 days later (to stay clear of the wash sale rule) at $125 (let’s say), and hold it until $150 at year 10.
Under the second strategy, the government only taxes me on $25 of capital gain in GSG ($150 - $125), rather than $50.
I should know this … but what happens when you just have a net capital loss for a year? You can write that off, right? (And at what tax rate?)
My essential question is: what’s the difference between tax loss harvesting and just selling your dogs and getting a benefit for that?
Capital losses have to be deducted against capital gains first. The resulting tax break is whatever your capital gains rate is; if you have a lot of short-term capital gains, the tax break is bigger.
After you’ve exhausted capital gains, you can start deducting against ordinary income. But you can only deduct $3,000 per year against ordinary income. Any additional tax losses have to be deducted against future years’ taxes, which makes those tax breaks less valuable.
I’m not sure what you mean by the benefit of “just selling your dogs.” Maybe you mean that stocks you’ve lost money on are likely to keep on going down, so selling them allows you to avoid that loss. If markets are efficient, then that shouldn’t be true; whether the stock has gone down recently or not, its expected return going forward should be unaffected (provided its riskiness hasn’t been affected).
Surprisingly, there is a mild amount of momentum in individual stock prices (although not in market indices like the S&P 500). Stocks that have done well in the past 12 months on average (although certainly not always) outperform stocks that have done poorly in the past 12 months. On the other hand, stocks that have done well over longer horizons tend to have poor returns going forward. There are also short-run reversals; stocks that have done well in the past 30 days tend to slightly underperform the following month. Anyway, I think that the tax benefits of selling losers swamp the price momentum/reversal benefits in most cases.
So I still think I’m missing something. In this scenario you may be getting $25 of capital gains tax-free, but unless you no longer want to be in the losing position long term (which I assume isn’t the case since we’re assuming efficient markets and no particular view that a stock will be going down, etc), the next $25 of capital gains you get from the losing position will be tax-free (the difference between current value and cost basis). Even if the losing position doesn’t, you can always net that against gains in the future. It seems to me that the question is only on which position you want to have $25 of cap gains tax-free, not an absolute about of tax savings. It seems like you should be relatively indifferent to when you take the capital losses. Granted, you lock in the $25 of gains in your example now as opposed to taking it later, but that’s the only difference. At the same time, though, you’re losing 1 month of return because the cash is sitting on the sidelines before you can buy back into the positions. Or are my assumptions about cap gains still being netted in the future off?
Another somewhat related thought, should we really be netting out the first $3K of long term capital losses? By doing so we save the 15% of capital gains tax on the profitable position, but if we don’t, we can net it against income. Assuming that our income tax bracket is higher than 15%, doesn’t it save us more to net against income?
Fifty, the difference is that you get the tax break this year rather than in some future year, so it’s worth more. (You can immediately invest the tax savings.) And you don’t need to have your proceeds sitting in cash. I had sold a Vanguard international fund, and I used the proceeds to immediately buy another Vanguard international fund which is a pretty close substitute.
You’re right that being able to net capital losses against ordinary income is more lucrative, but you can only deduct a small amount of losses against ordinary income. Also, in my case, I had wanted to reduce my commodities position (based on the evidence that there’s momentum in commodities returns, and this has been a crappy year for commodities), and to do that now meant incurring a short-term capital gain which is taxed at the ordinary income tax rate.
FiftyFive, thinking about it more and working out some arithmetic examples, I realize that I had a slight misconception about how the benefits of tax-loss harvesting worked, and your point about tax-free capital gains in the losing position has a lot of truth to it.
Let’s start with the case where you will realize no capital gains in the next ten (say) years, but you have $30,000 of capital losses this year. You should absolutely realize all those capital losses this year, because it will reduce the next ten years’ tax bill by $3000 times your marginal tax rate. You can immediately invest each year’s tax savings on April 15.
Now let’s say that, for whatever reason, you have to realize a capital gain this year. Again, you should sell securities with capital losses to offset the capital gains and reduce your taxes.
The point I was confused about is whether you should INTENTIONALLY realize capital gains that you wouldn’t otherwise realize in order to offset your capital loss. It’s here that FiftyFive’s point is right on. If markets are efficient, to a first approximation there’s no reason to prefer having the cost basis of your winning investment stepped up versus your losing investment.