Recently, I have been spending a lot of time on the baseball diamond coaching my son's Little League team. One of the things I love about baseball is the excellent life lessons that can be learned while playing this wonderful game. One of the surprising things I have learned recently is that baseball can teach us about how tax-loss harvesting works.
For a little context, tax-loss harvesting is the process by which an investor sells an investment held in a taxable brokerage account at a loss and buys a similar investment in order to participate in the inevitable market recovery. By selling at a loss, the investor gets to enjoy a tax benefit. You can use capital losses to offset capital gains, allowing you to rebalance your investment account in a tax-efficient manner. The realized capital losses offset any gains to help reduce your tax bill while you are keeping your investment portfolio aligned with your financial plan and your long-term goals.
If you don’t have capital gains to offset the capital loss, you can use the capital losses to reduce your ordinary income, up to $3,000 per year. Click here for more info.
You are allowed to “carry forward” your unused losses indefinitely until they are completely used up. (Make sure your CPA is helping you do this by using IRS form 8949)
Selling your investments at a loss can help to lower your tax bill. However, you have heard me consistently say that you should never sell at a loss because the market eventually recovers and comes back. You want to be invested in the market to participate in its eventual recovery. Selling at a loss locks in your losses and can cause your financial plan to be off track.
Best of both worlds?
Can you simply sell your investment at a loss (to get the tax benefit) and buy it back the next day to participate in the recovery? The answer is No, unless you want the IRS knocking at your door!
The Wash Sale Rule
The Wash-Sale Rule states that, if an investment is sold at a loss and then repurchased within 30 days, the initial loss cannot be claimed for tax purposes. In order to comply with the Wash-Sale Rule, investors must therefore wait at least 30 days before repurchasing the same investment. In all there is a 61-day window that includes the 30 day prior to and after the sale, plus the date of the transaction, where you cannot purchase shares of the identical security sold at a loss or shares of a substantially equal security. To learn more about the wash sale rule click here. You can't, for example, sell one ETF and buy another company's ETF tracking the exact same index containing the same companies. It’s important to note that the wash sale rules extend across all the accounts in your investment portfolio from an IRA to your 401(k) and taxable brokerage account. You can’t sell an investment at a loss in your taxable account and buy it back in your IRA.
How to Avoid the Wash Sale Rule
So how do you balance this? Selling at a loss for the tax benefits while remaining invested to participate in the recovery?
You can avoid the wash sale rule by purchasing an ETF that is not materially the same as the one you sold. The way to do this is to find one that tracks a different index. For example, selling the S&P 500 and purchasing one that tracks the Russell 1000. Or selling a small cap growth ETF and purchasing a small cap value ETF.
This is where baseball comes in.
It would be like trading a shortstop like Fernando Tatis of the Padres for Trea Turner of the Dodgers. Both are excellent players and great at what they do and would help any team to succeed on the field. Fernando Tatis played shortstop while Trea Turner played second base last year. They played slightly different positions (tracking a different index!) but Turner could be moved over to shortstop if Tatis were out on injury. Trea Turner's play would help the team to win. When Fernando Tatis comes back from injury, he could resume playing shortstop and Turner could go back to second base or be traded away.
For the basketball fans among you, Kevin Durant is a power forward for the New Jersey Nets. He is a fabulous player and has won 2 championship rings. Steph Curry is also a fabulous player and a shooting guard. He plays a different position than Durant (tracks a different index) but having him on the court will give any team a better chance of winning.
While my examples might be overly simplified, they illustrate the concept of how tax-loss harvesting works in terms of the wash sale rule. It’s important to remember that tax loss harvesting is not simple, and you must take caution to avoid the common pitfalls and landmines. But, if you do it correctly you this tactic can help you manage your portfolio in a more tax-efficient fashion. Carefully navigating volatile markets while keeping your investment allocation in balance can lead to an improved financial situation over the years.
Please do not hesitate to contact the office if you have any questions.