Example Strategy for Tax Loss Harvesting

What follows is my personal opinion and is not investment advice, please do your own research and contact a certified investment adviser / lawyer. Use at your own risk and don’t do this if you don’t understand it.

Summary: Tax loss harvesting is a massive gain and a must do for any smart investor. You don’t need to pay any 3rd parties like Wealthfront, Fidelity, Vanguard, or Betterment to do it, you can easily do it yourself and capture the benefits.

I had heard a lot about how tax loss harvesting could help your portfolio and didn’t really understand it. A lot of companies are pitching it as a service like Wealthfront and Betterment, but I wanted to know myself if it would work and if I could do it myself. So I built a sheet to test things out.

In my tax loss harvesting example, I used the complete daily close history data for the Russell 2000 index from January 1, 2001 to August 12, 2019. I built an algorithm that would sell anytime there was a taxable loss to capture it.

How Can I Do Tax Loss Harvesting In My Portfolio?

  1. Review your portfolio for significant unrealized losses in any stock or fund position on a regular basis. Daily review will capture the most losses, but you are probably fine doing it monthly or even quarterly.  Example: I invested $1,000 in Coca Cola on January 1st, 2019. On July 1st, 2019 the stock is down to $500. I still believe the soda industry and Coke especially will go back up though.
  2. When you have a taxable unrealized loss, you find the stock or fund that most closely mimics the stock you are selling without violating the IRS wash-sale rule (You aren’t allowed to sell a security at a loss than purchase the same or substantially identical security within 30 days). Example: I identify Pepsi (or maybe a Coke bottler) as a stock very similar to Coke with matching stock chart history. Pepsi does not violate the wash-sale rule, though a call option on Coke would. 
  3. Now sell the original stock at a loss and immediately reinvest those funds in the security you identified in step 2. Example: I sell my Coke for $500 and use those funds to buy $500 of Pepsi.
  4. If you really loved your original security most, then after the IRS wash-sale rule has passed by you can sell the new security and repurchase the old security. Example: I wait 35 days then sell my $500 of Pepsi and repurchase Coke again.
  5. At the end of the year, I can write off my loss on my tax return and pay that much less in taxes. Example: $500 realized loss on Coke at year end, which at my 39% tax rate means I get to keep $195 instead of paying that money to the government.
  6. This strategy assumes you use a Warren Buffet style buy & hold strategy… if you constantly sell stocks with just small realized gains as well this will not help you as much since you will pay taxes on the lower basis you now have for any growth in your stocks. However, if you hold for a long time the money you save will grow untaxed.

Here is the calculation you can use to estimate your savings from tax loss harvesting: 

Percentage you lost on the original security * Percentage you pay in taxes *  = tax loss harvesting savings. Keep in mind this works mostly with long run multi-year buy and hold strategies.

Example: 50% loss on Coke * 39% tax rate = 19.5% of my losses get put back in my pocket.

The key here to understand is that if you pay a high tax rate and if you have a significant loss on any stock or fund or bond, you should follow the tax loss harvesting process above to put money back in your pocket.

Over the long run when I tested this on the Russell 2000 index with daily closes, the portfolio that used tax loss harvesting would be 19.2% larger at the end of 20 years than the portfolio that did not. Keep in mind this changes based on what you actually invested in and how big those losses are and how high your tax rates are. If you sold at the end of 20 years, your gains would be smaller (12.7% instead of 19.2%) due to the lower basis. The longer you hold, the more you gain from the growth in your tax savings.

 

Published by

Joel Gross

Joel Gross is the CEO of Coalition Technologies.