Tax loss harvesting
Tax-loss harvesting is selling investments in your taxable account that have lost value since you purchased it, so that you can offset those losses against your taxable investment gains. An easy example is that if you sold your Facebook stock for a $10,000 gain in 2016, and you are sitting on losses in Apple stock of $15,000, you can sell your Apple stock, offset the Apple losses against the Facebook gains, and apply the $5,000 of left over losses towards future gains since they carry over to future years. At the 15% capital gains tax rate, offsetting the losses against the gains would save you $1,500 in taxes.
It is important to keep fees in mind when harvesting tax losses. Early in the year, it is generally not worth paying a $10 trading fee to sell a stock and then another $10 trading fee to buy it back just to harvest a small loss, such as $200. Keep in mind that tax-loss harvesting is used to keep your long-term capital gains from being taxed at 15-20% or your short term gains from being taxed at your ordinary income tax rate of 10-40%. So paying $20 in fees to harvest $200 in losses that will offset long-term capital gains taxed at 15% means that you are paying $20 to save $30. At the end of the year, if you have some short-term or long-term capital gains that you need to offset, then pay the $20 to save $30, but throughout the rest of the year, I would aim to tax-loss harvest larger amounts and keep costs down. If you tax-loss harvest throughout the year when it is cost-efficient to do so, then you can frequently put yourself in a position to pay few, if any, capital gains down the road.
Wash sale rules
When you sell a security at a loss, you cannot buy that security back within 30 days before or after the sale, or else the loss is called a “wash sale” and cannot be used to offset gains. In the example above, if you sold Apple and then bought it back ten days later, then the $15,000 loss on Apple cannot be used to offset the $10,000 of Facebook gains, since you purchased Apple stock within 30 days of selling it. To clear a prior wash sale, you have to sell the repurchased security and then not buy it again for 30 days on either side of that sale (the 61 day rule). If you clear the prior wash sale in the same tax year, then there is no tax effect of the prior wash sale. For example, if you sold your Apple stock at a loss on May 1, 2016 then repurchased it on May 15 (a wash sale) then sold it on December 30 and did not purchase it again until February 2017, then the prior wash sale is cleared by the December 30 sale, and there is no tax effect in 2016. If you had instead waited until January 1, 2017 instead of December 30, 2016 to sell the stock that you purchased on May 15, 2016 (which caused a wash sale), then those $15,000 of losses cannot be used in 2016. This mistake can cost you thousands of dollars, so it is important to keep the wash sale rules in mind.
The wash sale rules apply across accounts (so you can’t sell in a taxable account and purchase the same security in a tax-deferred account a few days later). The day of the sale is not included, so you have to wait until the 31st day after the sale to purchase the security.
How to tax-loss harvest while avoiding the WASH SALE RULES
If you have a loss on an investment that you still want to own, then there are some strategies to avoid the wash sale rules and still harvest the losses. The first is to buy more of the investment (or a call option if available) you want to sell, then sell your original investment at a loss 31 days later, that way you still own the investment and have harvested the losses. This method may cause too much risk if you hold too much of the investment, and it requires more planning and luck than is practical in most cases. The second is to buy an ETF or other security that tracks your favored investment and hold it for the 30 day waiting period after you have sold the investment. For example, if you were to sell IBM at a loss but still want to be exposed to it because you think it will increase in value in the next 30 days before you can repurchase it, then you could buy an ETF such as DIA, 6% of which is IBM stock, to hold for those 30 days. It is an imperfect option because none of the ETFs perfectly correlate with IBM, so IBM could go up in those 30 days but your temporary replacement, DIA, could go down. Note that if you sell an ETF to harvest losses, you can purchase a similar ETF by another company that tracks the same stocks without triggering a wash sale.
One of my roles as an investment adviser is to minimize the costs and taxes of your investments. Maximizing tax-loss harvesting, minimizing capital gains and avoiding wash sales are an important part of that strategy. If your adviser is not keeping those rules in mind, then you may need to consider another adviser. Also, the wash sale rules are complicated, and wash sales cannot be cleared up retroactively but they generally can quickly be fixed, so make sure to discuss them with your adviser or CPA prior to December 31 of each year.
Disclosure: I/we own shares in Apple, Facebook and IBM. We have received no compensation for mentioning those companies in this article.