A friend of mine who reads this blog emailed me recently for advice about about tax loss harvesting (abbreviated TLH in this article). The allure and promise of TLH, to pay less in taxes, is indeed sexy. Who doesn’t like this promise?
The purpose of this article is to convince you that the above claims are hogwash. Or perhaps I’m wrong and the purpose of this article is to expose how ignorant I am on the topic.
Wealthfront’s TLH claims right on its homepage.
The basic premise of TLH:
The purposes of TLH is to realize losses (i.e. sell shares that have gone down in price) to get tax relief today. My major qualms with TLH are the following:
- By TLH today, you’re simply lowering your cost basis. However, this lower cost basis means higher taxes down the road. None of the proponents of TLH fully discuss the ramifications of higher taxes down the road.
- TLH oftentimes presumes you have capital gains to offset. However, if you’re a tax-conscious long-term investor you should optimally not have gains to offset.
- In the absence of capital gains, one may use capital losses can offset up to $3k of ordinary income (e.g. W2 wages). Any “unused” tax losses carried forward to future years.
Let’s quantify the benefits of TLH then:
- You purchased $100k of shares and they went down to $70k during a recent market downturn. You sell and generate a $30k loss.
- You immediately purchase a “not-substantially identical” tax loss harvest partner (e.g. sell VTSAX and buy VFIAX). Since you’re a prudent long-term investor, you don’t sell the $70k of VFIAX for decades.
- This is an minor nuisance with TLH; you end up in an investment that you may not have wanted (e.g. VFIAX rather than VTSAX).
- Since you have no investment gains, the $30k of tax losses cannot be used to offset any investment gains. Instead, you use $3k/year of losses to offset ordinary income with any used losses “carried forward” to future years.
- Your marginal (federal + state) tax rate on labor income is 33.333%.
- You’ll benefit $1k (=$3k*33.33%) in reduced federal + state taxes each year for 10 years.
- Assume you sell the investments in your brokerage account in 10 years. Because your cost basis is $30k lower than it would have been had you not TLH’d, you’re going to pay more taxes at that point. Assume that tax law doesn’t change significantly over the next 10 years (a big assumption) and that long-term capital gains are still taxed less than labor income. Let’s assume that your marginal tax rate on investments (federal + state) is 25%. Therefore, you’ll face a $7,500 (=$30k*0.25) higher tax burden in 10 years as a result than had you not TLH’d today.
- Let’s compute the present value of this entire transaction, appropriately accounting for the fact that the TLH has increased our long-term investment taxes due to the lower cost basis. Assume a 5% discount rate. Assume first tax benefit is claimed immediately and that the eventual sale of the securities is 10 years down the road.
- PV = $1k + $1k/(1.05) + $1k/(1.05^2) + $1k/(1.05^3) + $1k/(1.05^4) + $1k/(1.05^5) + $1k/(1.05^6) + $1k/(1.05^7) + $1k/(1.05^8) + $1k/(1.05^9) – $7.5k/(1.05^10)
- PV = $3,503.47
Discussion of Results:
- A present value of $3.5k of TLH benefits is not nothing, but it’s certainly not the panacea that is worth the disproportionate amount of attention that investors give to it.
- I think the disproportionate emphasis of TLH comes from marketing from robo-advisors and the fact that uniformed investors don’t appropriately account for the “costs” of TLH (the higher tax burden down the road).
How we could improve upon our benchmark results:
- Rather than selling the TLH’d shares in 10Y, we could have completely avoided the corresponding increase in capital gains taxes with the following:
- Donating the appreciated shares (now with lower cost basis) to charity.
- Dying, so that our heirs benefit from the “step-up in cost basis” at death.
- Doing something similar to GoCurryCracker, and exploit the 0% region for federal taxes on LTCG (e.g. https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates).
With the above framing, TLH with the intent to donate low-cost-basis shares to charity/heirs is indeed pure arbitrage. But this isn’t what I hear promoted on the internet.
Is it worth paying a robo-advisor to TLH for you?
Let’s assume a 0.5% AUM fee. Assume you have $1M with an advisor. Each year you’re paying $5,000 (=$1M*0.5%) in fees to achieve $1,000 in TLH benefits (and recall that these benefits are diminished once we appropriately account for the higher tax burden downstream).
Pushing TLH strategies to the forefront of their marketing materials is a baseless attempt to convince you that their AUM is fairly earned. It is not.
Despite all of the above, let’s say you still want to TLH. Here’s how I’d do it:
- Have all tax-sheltered accounts at one brokerage (e.g. I have all of my 401k, IRA, HSA at Fidelity).
- Have all taxable accounts at another brokerage (e.g. I have all of my taxable stuff at Vanguard).
- Turn dividend reinvestment off in your taxable brokerage account.
- Why is the above important?
- A “wash sale” occurs when you sell a security and buy one that is “substantially identical” within 30 days. Since VG and Fidelity track slightly different indices (for their total US stock market indices, for example), you can have dividends reinvested automatically in your tax-sheltered accounts without fear that these auto-reinvestments of dividends will invalidate your TLH efforts in your taxable brokerage account.
- When you go to sell, be sure you have an appropriate “tax loss harvesting partner” (e.g. VTSAX and VFIAX). Google “tax loss harvesting partner” for more examples. Ensure that you’re not selling a security that you bought less than 30 days ago in your taxable brokerage account.
- If you don’t want to stay in the “partner” security after 30 days, then go back to your original investment.
- I’d look for large investment losses so that you only have to bother with this once a decade or so. Anything less than $10k in losses does not strike me as being worth your time.
- Importantly, since you’re a prudent long-term investor, you should avoid selling appreciated shares to generate taxable gains in the first place (unless you’re in the GCC sweet spot of 0% MTR).
I realize that TLH may be useful in the following scenarios:
- Allowing an investor to avoid LTCG when there is a big liquidity event (e.g. paying for kid’s college).
- Helping an active trader to offset big gains.
I just don’t think the above are sufficiently important to warrant the disproportionate amount of attention I see to TLH on the internet. The much more impactful way of avoiding taxes in a taxable brokerage account is the following:
- Buy index funds and hold them until you die.
- If you can’t wait that long, then:
- Hold them for as long as you can
- Or dump them to charity
- Or wait to sell until you get to the GCC 0% region
- If you can’t wait that long, then:
I realize the above isn’t sexy advice, but it’s the best advice one could give for minimizing one’s tax burden while investing in taxable brokerage accounts.
Do you find the assertion that TLH is overrated convincing? Or is the above analysis flawed/unconvincing? If so, what am I missing?