How to Reduce Your Tax Bill with Tax-Loss Harvesting
Now that we’re in the final innings of 2021, it’s a good time to assess how your investments are performing and how they’ll impact your taxes. Your stock portfolio may no longer be allocated the way you intended it to be or you may have pent-up earnings and/or losses in specific holdings. In either case, you may want to consider tax-loss harvesting, a technique used to help rebalance stock portfolios and reduce tax bills. Today, we’ll talk about how best to apply tax-loss harvesting and when to not do it at all.
How a Portfolio Gets Unbalanced
Let’s say you started the year off with a $10,000 portfolio. You decided to make equal investments in Apple and VTI (Vanguard Total Stock Market Index Fund), a 50% allocation in each.
At the time of writing, Apple has underperformed the overall stock market and has only returned 7.44%. On the other hand, VTI has returned 15.5%. This means that your Apple investment has grown to $5,372 and VTI is now $5,775. You now have 48.19% invested in Apple and 51.81% in VTI. If this trend were to continue, the imbalance would continue to widen over time. This is how portfolios become unbalanced.
Taxes When Rebalancing a Portfolio
Are unbalanced portfolios that bad? Yes and no. It really depends on your goals and risk tolerance. What an unbalanced portfolio does tell you, though, is that some portion of your portfolio isn’t giving you the same return as the rest. That portion could be outperforming or underperforming. Both scenarios will result in an unbalanced portfolio. It’s a signal to you that you might want to sell some parts and buy something else. But if you do that, you need to understand the tax implications of buying and selling stocks.
Let’s first talk about capital gains and losses. Below are the current short-term and long-term capital gains rates:
| Short-term capital gains | Long-term capital gains | |
|---|---|---|
| Federal | Between 10 and 37% | Between 0 and 20% |
| State | Between 0 and 13.3% | Between 0 and 13.3% |
Everyone is taxed the same rates at the federal level. But your tax rates will vary based on which state you live in. For example, Texas will have a 0% tax rate but California’s highest, marginal tax rate is 13.3%.
For the sale of an investment to qualify as long-term capital gains, you must sell after owning it for 366 days or longer. If you sell within a year of purchasing the investment, the sale will be taxed as short-term capital gains.
Obviously, you want to pay as little as possible to Uncle Sam. That means, you should almost always prioritize selling for long-term capital gains. Almost always? Yes, sometimes it’s best to sell investments for short-term capital gains when you have short-term capital losses to offset, or vice versa. I’ll get into this detail a bit later.
Efficient Stock Sales
When a stock is sold, you either sell it for a capital gain or loss. Every dollar of capital gains is taxed. However, you may offset those gains with losses (i.e. selling an investment for a loss). At the end of the year, you essentially sum up your long-term gains and subtract your long-term losses. You then sum up your short-term gains and subtract your short-term losses.
So it looks like this:
Total long-term gains or loss = long-term gains + long-term losses
Total short-term gains or loss = short-term gains + short-term losses
In both cases:
If gains exceed losses, you are net positive & end up with a gain.
If losses exceed gains, you are net negative & end up with a loss.
If the sum of all long-term & short-term gains/losses is negative, you can write off up to $3K of those losses from your ordinary taxable income (which is the highest tax rate you pay). Unfortunately, this is the limit regardless of your marital status. If you have more than $3K in capital losses, anything above that amount will be carried over to the next year for future use.
To clarify, any stock sale can offset another stock’s sale. You aren’t limited to offsetting Company A’s stock with Company A’s stock. You can mix and match.
Least Effective Strategy
The least effective way to harvest losses is by using short-term losses towards long-term gains because long-term gains would’ve been taxed at the best tax rate. If you had used those same short-term losses towards short-term gains, then you’d be maximizing your harvested losses by putting them towards gains with the highest tax rate.
Granted, if you did end up using short-term losses against long-term gains, it’s not the end of the world. While you could have paid taxes at the best tax rates by reducing your short-term losses, you’d still be paying fewer taxes overall.
Example 1 - Result of $5,000 in short-term losses
| Highest federal tax rate | Taxes Due | |
|---|---|---|
| $3K short-term gains | 37% | All short-term gains were offset by short-term losses, leaving $2K of short-term losses to use towards long-term gains. $0 taxes due. |
| $5K long-term gains | 20% | The remaining $2K of short-term losses offsets $2K worth of long-term gains. So: $3,000 x 20% = $600 |
| Total | 20% tax rate | $600 tax bill |
So in this example, while the outcome is still good, reducing the short-term losses from $5K to $3K to only offset short-term gains would allow us to pay all $5K in long-term gains at the best tax rate. While the example uses the highest possible long-term tax rate, it’s very possible to be as low as 0%.
Example 2 - Result of $3,000 in short-term losses
| Highest federal tax rate | Taxes Due | |
|---|---|---|
| $3K short-term gains | 37% | All short-term gains were offset by short-term losses. $0 taxes due. |
| $5K long-term gains | 20% | $5,000 x 20% = $1,000 |
| Total | 20% tax rate | $1,000 tax bill |
Compared to Example 1, we reduced our short-term losses from $5K to $3K in Example 2. While we do end up with a higher tax bill ($1,000 vs $600 in Example 1), we pay taxes on the entirety of our long-term gains at the best tax rates. Again, I used the highest long-term tax rate of 20%, but the lowest long-term tax rate could be 0% depending on your taxable income level.
Most Effective Strategy
In the other scenario, where you end up with net short-term gains but have net long-term losses, your long-term losses offset your short-term gains. So instead of paying the high tax rate for your short-term gains, your long-term losses reduce your tax bill.
In my opinion, this is a good idea because short-term capital gains rates are the worst rates you can pay. In fact, if your long-term losses exceed your short-term gains, that means you will not have to pay any short-term capital gains (the worst tax rate) and you get to write off up to $3K from your ordinary taxable income for the year. And, again, ordinary taxable income also has the highest tax rates.
Similarly, selling short-term losses to offset short-term gains also makes sense. This strategy also reduces how much you’d pay at the highest tax rates.
Stock Lots
In order to apply these tax-loss harvesting principles, you need to be able to discern the difference between short & long-term winners vs losers in your portfolio. This is where stock lots come into play.
A stock lot is a group of stocks (1 or more) purchased at the same time. Every time you purchase a stock, a new stock lot is created for that transaction.
Below is a screenshot of one of my holdings that I’ve purchased several times in the past 12-16 months:
Depending on your broker, examining your stock lots will look different. And oftentimes, they explicitly call out which lot is short-term vs long-term. In the above screenshot, I have to do the calendar math myself. Everything that was purchased in 2020 happens to be long-term gains; and the rest are short-term gains.
But as you can see, there’s an option to sell specific lots of this stock. You can pick which ones to keep vs sell, based on long-term vs short-term classification and how much you want to sell. You can even sell portions of a lot, without having to sell the whole thing. The choice is yours!
The Wash Sale Rule
If you repurchase the same security you sold for a loss within 30 days of the sale, your loss is disallowed. This IRS rule prevents investors from selling only for tax benefits. This is known as the wash sale rule.
Without the rule, people would simply sell a ton of losses at the end of the year and repurchase them right at the beginning of the next year.
Conclusion
In an ideal world, I have no losses at all and only have to worry about long-term vs short-term gains. In this case, unless I were desperate for cash or could sell with little to no taxes, I’d never sell anything for a short-term gain and only sell long-term winners and pay taxes at the lowest possible tax rates.
However, most people do have losses. This year, I have sold some short-term winners which would be taxed at the highest tax rates. So I will certainly be selling as many short-term losers as possible to offset those gains. This helps me avoid a hefty tax bill this year and forces me to rebalance my portfolio into a more diversified one using index funds (I want to move away from holding individual stocks entirely as I get older and more risk averse).
If you have any questions about this topic or have any other efficient tax strategies, share with the community below! You can also contact me directly, and I’d be happy to discuss further.
