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Tax-Loss Harvesting Deep Dive
How to save on taxes with loss harvesting & direct indexing.
Noyack Wealth Weekly
October 13, 2024
As the saying goes, there are only two certainties in life: death and taxes.
Unfortunately, I can’t do much to help you with the former – but I do have a few tips when it comes to the latter.
Today, we’re talking about tax minimization.
Sure, paying taxes might be unavoidable. But if you play your cards right, you can lower the amount you pay by a surprising amount – all in a completely legal, IRS-approved manner.
Here’s what I’ve got in store for you today:
Understanding the basics of tax-loss harvesting.
How to combine tax-loss harvesting with direct indexing for even more power.
And an expert interview with Samuel Harnish, a CFA & CFP who specializes in helping investors minimize taxes.
Let’s roll!
The Basics of Tax-Loss Harvesting
Judging by the name, tax-loss harvesting might sound like a super sophisticated strategy.
But it’s much simpler than you might think and can help unlock substantial tax savings.
What are capital gains?
Tax-loss harvesting relies on strategically using capital losses to offset the taxes you owe.
To understand what that means, it’s actually a bit more helpful to start with the subject of capital gains:
When you sell a stock that has increased in value, you’ll generally owe capital gains taxes on the amount that you profit.
If you buy a share of stock for $100, for instance, and then sell it for $120, the $20 difference is your capital gain – which is usually taxable.
Depending on your tax bracket and the length of time you held the asset, you’ll owe anywhere from 0% to 40.8% on the gain.
Capital losses are the opposite of capital gains
Capital losses, meanwhile, are exactly the opposite of capital gains.
If you buy a stock for $100 only to see its value decline to $80 by the time you choose to sell, you have $20 in capital losses.
Sure, nobody likes to lose money on a stock. But there’s a silver lining: the amount of your capital losses can be used to offset capital gains.
What’s more, if you don’t have enough capital gains to offset, you can use capital losses to deduct up to $3,000 in ordinary income.
And here’s the secret weapon of capital losses – you can ‘carry forward’ any unused losses to future years indefinitely.
That means even if you don’t have capital gains to offset this year, you can accumulate losses until you eventually have gains to offset (like, for instance, when you want to sell highly appreciated stocks in your retirement years).
Beware the Wash Sale…
Based on what I’ve written above, you might think of a clever tactic to minimize your taxes…
If you have some losing stock, sell it to lock in the capital losses, and then just immediately repurchase the same stock – bam! Tax benefits without actually changing your portfolio.
Not so fast. While it’s a smart idea, the IRS is wise to this strategy, which is known as a wash sale.
To prevent abuse, the IRS says that you can’t sell an asset and replace it with a “substantially identical” stock 30 days after the sale.
Still, we can use this basic concept as the foundation of a similar, but legally allowable strategy – with a little help from direct indexing.
What is direct indexing?
You’re probably familiar with the concept of index investing (who isn’t these days?).
The basic idea behind index investing is to buy a fund that invests in a portfolio of a bunch of stocks (like the 504 stocks that make up the S&P 500 – yes, really).
But you can also cut out the middleman and just buy the underlying stocks yourself, a tactic known as direct indexing.
Why would you do this? It seems like a lot of work to just replicate the same portfolio.
There’s one big reason why – and, as you might guess, it has to do with tax-loss harvesting:
If you buy an index fund, you only have the option to sell every stock – by selling shares in the fund.
But if you do direct indexing, you can sell just a few stocks out of the hundreds that make up your portfolio. You can even purchase similar (but not identical) stocks to replace them.
This allows you to strategically sell your stocks to harvest losses without changing your overall portfolio exposure that much – and you can just rebuy the stocks after 30 days pass.
Expert Interview: Samuel Harnisch, CFA, CFP ®
Okay, I know I just threw a ton of information at you.
So, to help us understand this world a bit better, we called in an expert - Samuel Harnisch, a Chartered Financial Analyst and Certified Financial Planner.
Samuel runs Quantitative Financial Strategies, an investment advisory firm that specializes in tax-aware investment strategies. He holds a Master's degree in Applied Quantitative Finance and previously worked at PIMCO.
Check out our conversation with Samuel below, and be sure to check his blog and LinkedIn for more insights on tax minimization.
Can you explain the basics of tax loss harvesting and how it can benefit individual investors?
I would explain tax loss harvesting as systematically taking advantage of the inevitable outcomes in your portfolio.
So, let's say you have a portfolio of 100 stocks. A few dozen or so of them every year will be down. We'll have lost money, even in a year where the entirety of the hundred stocks is actually up.
Tax loss harvesting is taking advantage of those positions that have lost value. You sell them, which is called “realizing the loss.” And what's really important is that when you sell them, you immediately purchase a similar stock so that you maintain the exposure that you previously had.
Over the long term, your portfolio performance will look similar, but along the way, you're able to pull out tax alpha.
Can anyone do this, or are there limitations?
Technically anyone can do it, although working with a trusted advisor makes the process easier. What you do have to be careful of are wash sale rules. You cannot buy back the exact same security that you sold within a 30-day period.
Are there any potential drawbacks that investors should be aware of?
I think the biggest thing is being mindful about whether the tax benefits are worth it. If you are a buy and hold investor with mainly tax-advantaged accounts, you might not have substantial capital gains to worry about.
Some people become so obsessed with taxes that they'll make suboptimal decisions. The investment strategies you’re using should be sound philosophically with the tax benefits as a cherry on top.
Are there any additional strategies investors might consider?
One thing to be aware of is that with a long only direct indexing strategy, the tax benefits drop off substantially after the first two or three years. If you want something that's persistent through time, you have to look at versions that include shorting too. I incorporate these enhanced versions when working with clients.
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