Here’s How The Rich Use “Tax Loss Harvesting” To Improve Their Portfolio Returns!
I try not to get too technical with my articles because I don’t want them to be boring.
But you’re here to learn right? To better yourself and your family’s financial situation?
If this one is a bit too advanced for where you’re at in life, you should bookmark it and come back to it later when you’re more ready.
But keep in mind:
At some point, you need to realize you have to learn the hard stuff too. Because think about it, if it were that easy, everyone would be rich!
If You’re Subscribed to this Blog, You Have A High Chance of Building Wealth
I share everything I know on this blog.
Everything I’ve learned along the way to go from having $500 at age 18 to becoming a millionaire by age 31.
And for that reason, at some point down the line, you’ll realize you’ve hit a critical juncture where you’re maxing out all the tax-advantaged options at your disposable.
What a privileged place to be, right?
For example, for me and my wife, that would be our Traditional IRA ($5,500 x 2 = $11,000) + our Traditional 401K ($18,000 x 2 = $36,000) per year.
Related: Investing 101
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For some of you who get profit-sharing from your company, the limit on the 401K side is a lot higher. But I’ll spare you the details. Since having $47K come out of your income, per year, is a luxury that few can afford.
Having said that, if you’re diligent and like to prop up some precautionary measures against worst-case (black-swan type) scenarios, you might save into a taxable account for a rainy day.
Or if you’re lucky enough to max out your tax advantaged accounts, including vehicles like HSA’s (if available to you), then tax-loss-harvesting is absolutely the way to go.
What is Tax Loss Harvesting?
According to Betterment, tax loss harvesting is “the practice of selling a security that has experienced a loss.
By realizing, or “harvesting” a loss, investors are able to offset taxes on both gains and income. The sold security is replaced by a similar one, maintaining an optimal asset allocation and expected returns.”
In other words, it’s a way for you to take some lemons and make some refreshing lemonade!
If the market goes down and you take a hit, you might as well use the opportunity to realize those losses and take the tax advantages that it provides. Why not?
Why Tax Loss Harvest?
At some point, it’s more about how much you get to keep away from the tax man, rather than making more in income.
I say this because once your income hits the 50%+ tax bracket (federal + state income), every additional dollar you make has less utility.
In other words, you get some severe diminishing returns.
So you’ll end up spending more time on trying to figure out how to maximize your tax efficiency so you can keep more of each dollar you make. That’s why tax loss harvesting is so important because it’s one of the only free lunches that are out there.
Here’s an Example of a Tax Loss Harvest Situation
Let’s say you inherited $100K from aunt Jemima’s passing (I know, I wish I had an aunt Jemima – but no, I wouldn’t want to wish her passing).
And because you’re money savvy, you make the smart decision to throw all of your windfall into an ETF in your taxable account.
Personally for me, I like to tilt because emerging markets still looks undervalued. So I would put it all into VWO (Vanguard’s emerging markets ETF). But given that VWO is already up roughly 24% YTD, it’s already been rockin and rollin all year; but now we’re due for a rough patch.
Kim Jong Un’s Shenanigans Takes a Hammer to the Market!
This is hypothetical. But it can happen (and FYI, just to be crystal clear, I have no relations to this maniac – even though we’re both Kims!).
So let’s say due to the increase in rhetoric and maybe even some additional nuclear tests, a ton of investors exit South Korea’s KOSPI stock market.
That’d have a direct impact on my emerging market holdings because South Korea is a big allocation in this ETF.
So again, in this situation, let’s say I temporarily lose a value of $10,000 from my emerging market holdings (again due to all the saber rattling and back-and-forth looney tunes type rhetoric).
Here’s what I’d do:
In This Situation, Rather Than Crying About the Loss, Make Some Lemonade!
You can sell the $90,000 remaining, and then reinvest it into SCHE (Schwab’s emerging markets ETF) or iShares like-kind fund (IEMG).
Because these are not “substantially identical funds” (but close enough), the IRS should allow this to go through and not be tagged as a “wash sale.” Now if you were to sell the VWO and then buy the index fund version of the same exact fund (VEIEX), then that would trigger a wash sale.
One thing to note though, is that the IRS doesn’t pay a whole lot of attention to this stuff. That said, it’s better to be safe than sorry.
So by doing this, you get a $3,000 (max allowed per year) offset in your income for that year or it’d offset your capital gains up to the same amount. And to put extra gravy on top of this already sweet deal, these losses are rolled over into future years!
Indefinitely until you’ve used up all of your losses! This is when you know you’re killing it with that KNAWWWLEDGE!
Ok, You Sold Me On This Tim! So How Do I Tax Loss Harvest?
Typically when you buy funds, the “cost-basis” method that is automatically used is called “average cost.”
So you’ll want to switch this to have a cost basis method of “specific ID” lots.
By having separate lots, you can pick and choose which lots are in the red, and sell those only and move them over to your partner ETF/Fund you’re using to do the tax loss harvesting.
Make sense? We’re making all kinds of cents!
To be optimal, you don’t want to use average cost since you’d have some capital gains thrown in the mix, if you’ve bought the fund over a period of time.
Alternatively, You Can Also Do This
Rather than buying into a similar fund, you can just choose to stay out of the market once you’ve sold your fund, for 31 days, before buying into the same fund again.
This will eliminate the need for a partner fund; but the downside is that you’re out of the market for a whole month and there’s a good chance the market will go up during that time period, which will make you feel like a buffoon.
This is why my preference is to always keep partner funds so that I’m never out of the market, for even a day.
You should also turn off the automatic investment from dividends and capital gains. Here’s why: you don’t want to negate your harvested losses through wash sales by having your dividends automatically purchase into the same fund within that 31-day window.
What Are Some Good Tax Loss Harvesting Partner Funds?
I’ve done the homework; and so, here are some of the partner funds I’m currently using, and/or have used in the past:
US Stocks: VTI/VOO/SCHB
International Stocks: VXUS/SCHF/VEA
Emerging Market Stocks: VWO/SCHE/IEMG
Is this the first time you’re hearing about Tax Loss Harvesting? What are your thoughts on it? And if this is a review of what you’re already utilizing, share your own experiences in the comments below!