I am on the record as skeptical of the value of paying a roboadvisor to execute capital-loss harvesting, but capital-gain and capital-loss harvesting is a subject that excites financial independence bloggers (e.g. here, here, and here), so I don’t want to brush off the subject completely.
For those unfamiliar, capital-loss harvesting allows you to offset capital gains you realized during a calendar year or, if none, apply up to $3,000 of losses against ordinary income (and roll unused losses forward to the next tax year) while capital-gain harvesting allows you to sell appreciated assets and pay the long-term capital gains tax rate on your profits. The key difference is that while capital losses are subject to the wash sale rule, capital gains are not, so you can repurchase substantially identical securities immediately with the proceeds of the original sale.
Two notes on the logic and illogic of these practices
There are two things it’s important to keep in mind about the practices of capital-loss and capital-gain harvesting.
The first is that these antics are entirely products of two decisions made by the authors of the current tax code: the ability to apply capital losses against ordinary income (thereby getting up to a 39.6% rebate on your bad investment choices) and the decision to tax long-term capital gains at lower rates than short-term capital gains. These are very bad decisions, but they are currently enshrined in law, so I don’t pretend to criticize anyone taking advantage of them.
The second is that under the most popular current interpretation of the tax code, the rules around wash sales are interpreted so loosely as to be practically meaningless. For example, selling an S&P 500 ETF and using the proceeds to buy a total stock market ETF is not treated as a wash sale, nor is the reverse transaction, despite their near-perfect correlation. Likewise the IRS doesn’t seem to object to selling a developed-market ETF at a loss and using the proceeds to buy one European and one Pacific developed-market ETF. This is a bad interpretation of a bad rule, but it is the current prevailing understanding of the rules.
This second point is important because it means your capital-loss and capital-gain harvesting doesn’t need to affect your overall asset allocation, since you can use the proceeds of your transactions to replicate your original holdings through differently-though-similarly-indexed ETF’s (I’m not a tax lawyer, and I’m definitely not your tax lawyer, so please consult with him or her before actually attempting this).
With that out of the way, I want to take a closer look at five ways you might, if you were so inclined, harvest capital gains and losses.
Harvest all losses
This strategy would work by identifying a certain number of correlated but not “identical” ETF’s, and swapping between them each time you see a loss, while keeping the 30-day wash sale rule in mind. For example, you could use the Vanguard 500 ETF and Vanguard Total Stock Market ETF, and sell on every day with a loss that brings your share price below your purchase price and move the money to the other, as long as the transaction wouldn’t put you in violation of the wash-sale rule (i.e. put you back in the original ETF within 30 days of sale).
It would be relatively easy to configure such a rule with stop-limit orders, although you’d have to actively execute the subsequent purchase order and actively monitor your wash sale compliance.
Harvest all gains
Another approach would be to look at your holdings just once a year and sell all your securities that have long-term capital gains, paying the lower long-term capital gains tax rate and using the proceeds to repurchase the same securities at a higher basis.
A sub-strategy here would be to only sell appreciated securities up to the total income limit of the 0% long-term capital gains tax rate ($37,650 AGI for single filers).
This strategy is far simpler than the above because it only requires you to know the date you purchased your securities, without needing to reallocate between similar-but-not-identical securities, capital gains not being subject to the wash-sale rule.
Every year-and-a-day, you could sell all your year-old securities and either deduct your losses or pay long-term capital gains taxes on your gains. The advantage of doing so would be to, over time, step up your cost basis more-or-less in line with inflation and price appreciation, while paying only the long-term capital gains tax rate and also accruing tax losses in down years to offset future capital asset appreciation.
This would require more extensive book-keeping and compliance with the wash-sale rule, but would only need to be done once per year, making it potentially less burdensome than the “harvest all losses” option above.
Offset all losses
One of the advantages of a diversified portfolio (I do not have a diversified portfolio) is that your assets aren’t supposed to be perfectly correlated. That means a portfolio with a total US stock market ETF, a total developing market ETF, a European developed market ETF and a Pacific developed market ETF will experience different returns at different times: some gains and some losses.
One way you could respond to this is to sell your loss-making securities (which can be either short-term or long-term) and offset those losses with gains-making securities, preferably those with short-term capital gains. You can use the proceeds of those sales to buy similar-but-not-identical securities to the loss-making ones, and identical securities to the gains-making ones.
If properly executed and reported, this should result in no net tax bill.
Offset all gains
The converse of the above strategy is to sell capital-gains-making securities and offset those with loss-making sales. The advantage of this strategy would be avoiding paying capital gains taxes (while securing a stepped up basis for your securities by re-buying your gains-making securities immediately) while also avoiding the necessity of tracking and rolling forward capital losses year to year.
The decision whether to pursue any or none of these strategies ultimately depends on a number of factors:
- do you believe touching your investments more often will make your investments perform better or worse than leaving them alone?
- what is your level of confidence in your ability to choose and successfully execute one or more of these strategies?
- what is your level of confidence that you understand the rules surrounding wash sales, capital gains, and capital losses?
- what is your marginal income tax rate, marginal short-term capital gains tax rate, and long-term capital gains tax rate?
My personal answers to those questions are “worse,” “low,” “low,” and “0%,” which explains why my interest in these strategies is purely academic. If your answers are “better,” “high,” “high,” and “40%,” then these strategies will understandably seem more appealing!