- Reader Case: Future Empty Nesters - September 25, 2023
- Full Circle - September 11, 2023
- Yield To Maturity Might Be Indicating a Bottom in the Bond Market - August 21, 2023
Today we’re going to go over a strategy that can be used to reduce your future tax bill on your investment portfolio, which just so happens to be super relevant right now: Tax Loss Harvesting.
What Is Tax Loss Harvesting?
When you’re still working your way towards your FI target, you’ll generally by only buying ETFs. Even if the market goes wonky and your target allocations go out of whack, you should be able to rebalance back to target by redirecting your monthly cash injections towards assets that have gone down. This is generally the right thing to do, because buying never triggers a taxable event.
Years later, when you finally pull the trigger on early retirement and ride off into the sunset cackling at your former boss, the situation changes. Now that you’re no longer putting money into your investment accounts and are instead pulling money out of your portfolio to fund your living expenses, you will be occasionally selling units. And when you do, you may have to pay taxes on the profit.
This tax is known as a the Capital Gains tax. Basically, here’s how it’s calculated.
Take the price that you sold your units at, then subtract the price you bought those units at (your brokerage should keep track of this for you as the “Cost Basis”), then multiply it by how many units you sold. This is your capital gain.
So for example, if you bought 1000 units of an ETF at $100, then years later after your retire, during a rebalance you sell 20 units of that ETF at $150, then your capital gain would be ($150 – $100) x 20 = $1000.
This capital gain would then get reported on your tax return and, depending on your post-retirement tax situation (i.e. whether you have side hustle income), this may result in tax owing on that amount.
But with some planning, it’s possible to offset that capital gain tax and potentially result in no taxes being owed. Here’s how.
The opposite of a capital gain is a capital loss. If you sell an investment for less than you bought it, you’ve realized a capital loss.
Capital losses are interesting in that if you report them on your tax return, you can use them to offset any capital gains you may owe. And if you don’t have any capital gains that year, those capital losses can carry forward into future years indefinitely.
So say you’re in the middle of an economic calamity, like say, a global pandemic. You’re looking at your portfolio and it’s a sea of red, with losses everywhere. One possible reaction would be to roll your eyes, angrily sigh, and go watch Tiger King on Netflix. Another would be to recognize that those losses are likely temporary and harvest them. If you do this, you will be able to carry them forward to a later date when they might come in handy in reducing your tax burden from future capital gains.
Interestingly, in the US, capital losses harvested in this way can also be used to reduce ordinary income, up to a limit of $3000 per married couple each year.
How Do I Perform Tax Loss Harvesting?
So how do I harvest these capital losses? Simple. You sell them.
But wait! Haven’t I been harping on and on that when times are rough you should hold onto your ETFs and never sell them at a loss? Well, yes, that’s still true. But harvesting capital losses isn’t just selling at a loss. You sell them, and then you immediately buy them back. This way, you’ve realized capital losses by your sale, yet you haven’t actually changed anything in your portfolio. You target allocation is still the same, and you’re still positioned to ride the inevitable recovery along with everyone else.
Two caveats to this maneuver though:
- Only do this in your taxable account. Capital gains and capital losses aren’t reported on tax-advantaged accounts like the 401(k) or the Roth IRA, so it makes no sense to do this in those accounts.
- Beware the Wash Sale Rule
Uh-oh. What is the Wash Sale Rule?
The Wash Sale Rule is a rule implemented by tax authorities to disallow exactly what we’re attempting to do here. The rule states that if you sell a stock at a loss, and then re-buy the exact same stock within 30 days, then the capital loss is disallowed and cannot be used to offset future capital gains.
The trick, though, is that the Wash Sale Rule only disallows capital losses if you sell and then re-buy the exact same stock. If you buy a similar stock with a different ticker symbol, the rule doesn’t apply because it’s not the exact same stock!
For active investors that buy individual stocks, they’ve taken advantage of this loophole by selling stocks from one company at a loss, then re-buying a highly-correlated stock from another company. For example, they’d perform a tax loss harvest by selling stock units of Bank of America, for example, and then re-buying Wells Fargo. These are two very closely related stocks that generally perform very similarly to each other, but since they’re two different companies the Wash Sale Rule doesn’t trigger and the capital losses are allowed.
It’s even simpler for us index investors. To get around the Wash Sale Rule, all we have to do is just switch to another ETF that tracks the same index but is run by a different company. Even though under the hood, the funds are 99.9% identical, because it’s run by two seperate companies they cannot be considered the same and therefore the Wash Sale Rule doesn’t get triggered.
For this reason, I like to keep a list of “shadow” ETF for each holding in my portfolio. These are alternative ETFs that track the same index, but are run by another company and therefore trade under a different ticker symbol, and whenever I need to harvest capital gains, I just switch to the shadow one, and then 30 days later (or whenever I remember), I switch it back.
For the Canadian workshop portfolio, here is my shadow ETF list.
|VAB||Vanguard Canadian Aggregate Bond Index ETF||ZAG||BMO Aggregate Bond Index ETF|
|VCN||Vanguard FTSE Canada All Cap Index ETF||ZCN||BMO S&P/TSX Capped Composite Index ETF|
|VUN||Vanguard U S Total Market Index ETF||ZUN||BMO S&P 500 Index ETF|
|XEF||iShares Core MSCI EAFE IMI Index ETF||ZEA||BMO MSCI EAFE Index ETF|
|XEC||iShares Core MSCI Emerging Markets IMI Index ETF||ZEM||BMO MSCI Emerging Markets Index ETF|
And for the American workshop portfolio, here’s my shadow ETF list.
|BND||Vanguard Total Bond Market ETF||AGG||iShares Core U.S. Aggregate Bond ETF|
|VTI||Vanguard Total Stock ETF||ITOT||iShares Core S&P Total U.S. Stock Market ETF|
|VEU||Vanguard FTSE All-World ex-US ETF||IIXUS||Shares Core MSCI Total International Stock ETF|
To see if an ETF would make a suitable shadow for your “main” ETF, simply pull up Google Finance and overlay the two ETF symbol’s price charts on top of each other. If they look like this:
Then they’re sufficiently highly correlated to use as a shadow.
One More Caveat for Americans: Short-Term vs. Long-Term Capital Gains
Oh and one more thing before we go.
For Canadians, a capital gain is a capital gain is a capital gain. But for Americans, the IRS differentiates between short-term capital gains and long-term capital gains. Basically, short-term capital gains are from sales of ETFs that you’ve owned for less than a year, and long-term capital gains are from sales of ETFs that you’ve owned longer than a year, and that’s important because short-term capital losses can only be used to offset short-term capital gains.
Similarly, long-term capital losses can only be used to offset long-term capital gains, so because your portfolio is going to be used for your retirement, you’ll likely be realizing long-term capital gains years down the road. Therefore, make sure any capital losses you harvest now you’ve owned for more than a year so they’d get classified as long-term capital losses. Otherwise, you might harvest the wrong type and then not be able to use it, which would suck.
OK that’s it for me! Is anyone out there planning to take advantage of the market turmoil to do some sweet sweet tax-loss harvesting? Let’s hear about it in the comments below!
How much does it cost to participate in the Investment Workshop? NOTHING. Because that's how we roll. All we ask is that you sign-up using the following affiliate links to keep it free forever:
Or, prefer to use a Robo Advisor? Check out Wealthsimple, and get your first $10,000 managed for free!
Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.