Selling Stocks at a Loss For Fun and Profit

Harvesting

Doing a different type of harvesting

So the markets are down, it took a while to realize because I try to to ignore the financial media. The good news is we get to save a lot of money on taxes.

When life gives you lemons, you make lemonade; when markets give you losses, you harvest them.

Tax loss harvesting has always been on the to-do list but seemed intimidating. It turns out it was easier than I thought and kind of fun, bearing in mind I might have a strange definition of the word fun.

Theory

To recap the basic idea, some over simplified examples:

  1. Someone hires you to move rocks from point A to point B for $25. You do the job and get paid: that’s ordinary income and it’s taxable. The government takes their cut, say 20% or $5 in taxes and you are left with $20 to do with as you want. You decide to save for early retirement and buy $20 of stock in Freedom 35 Corp (it’s a bargain). After you buy, the stock halves in value and is only worth $10. You stay the course, holding onto the stock. The stock price then skyrockets and your investment becomes worth $45. You decide it’s kind of silly to buy individual blog stocks and sell. The profit, $25 in capital gains, is taxable at a lower rate than ordinary income, and you owe another $1 in taxes.
    (Notice that you are better off trading stocks sitting on your ass instead of breaking your back moving rocks, you make as much money and pay less in taxes. Is thatgood enough motivation for early retirement? If capital is winning the fight with labor, you don’t want to be on the losing side..)
  2. The second example starts the same but after your stock halves in value you panic and sell at a $10 loss. The government is nice to you and lets you use your $10 in capital losses to offset any capital gains you may have. They are even nicer, and since you have no capital gains, you are allowed to deduct capital losses from your ordinary income. You are treated at tax time like you were only paid $15 for moving rocks ($25 in wages – $10 capital losses): you get a $2 tax refund for the extra money that was withheld from your rock moving salary. So in the end you lose $10 in the stock market to get a $2 tax advantage; not great but that will teach you to buy high and sell low.
  3. In the final example, when your stock halves in value you don’t sell but you would still like the tax deduction. You think you could just sell the stock, realize a capital loss, then immediately repurchase but the government isn’t stupid (well…) and they have rules to prevent you from doing that. However, you can buy a stock that behaves similarly to the stock you want to sell (without being substantially identical). So you sell your shares of Freedom35 Corp at a loss, but immediately buy $10 of Freedom36 Inc, figuring the difference in performance between the two will be negligible. Both Freedom35 Corp and Freedom36 Inc then rocket to $45. You are left with $45 worth of stock and you get a $2 tax refund. If you sell your new stock, you’d have to pay capital gains tax on the difference between the $45 sell price and the $10 purchase price.

By tax loss harvesting, you could possibly owe more capital gains tax in the future, but you are able to reduce your ordinary taxable income today. In most cases, you will be able to structure it in the future that you never pay any tax on the capital gains. So as they say: a tax deferred is a tax avoided. It’s like getting an interest free loan from your future taxes, that you will probably never have to re-pay. We are big fans of interest free loans.

Practice

We sold a bunch of shares of Vanguard Total International Stock, exchanging them for 90% Vanguard All World, and 10% Vanguard All World Small Cap. The performance between the former and latter pair should be equivalent, and market conditions at the time meant we could realize a ~$6000 capital loss on the sale. We plan on having minimal (if no) capital gains to report, so the net affect should be that we are able to reduce our taxable income by $3000 two years in a row. That’s possibly over $750 saved in taxes each year. Not bad for 20 minutes work.

Doing the transaction through Vanguard was easy and super straightforward, I’m not sure why I put off actually implementing tax loss harvesting for so long.

The Bogleheads forum has more information on tax loss harvesting, with what to look out for, and there is also a good writeup from the MadFientist.

Addendum

Frankly, I wish none of this was necessary, but I will hold my nose and do it for the tax savings.

There are “Robo Advisers” that will do the work for you, but they come with the cost of added fees. I had been on the fence, but after going through the practical exercise I’m not convinced it’s worth the extra cost: if in 20 minutes I could easily harvest enough losses to meet the income reduction limit, with a screaming baby trying to get attention, I don’t think I need to pay to have it done for me. Your mileage will vary, and I am sure the robo advisers will tell you they pay for themselves.

More generally, this really is a waste of everyone’s time: I want to hold my investments because I believe in them, not because they offer a slight tax advantage, similarly the government wants to raise funds not distort my choices. This is an example of smart people inventing and attempting to enforce complicated tax rules, and other smart people spending their time finding ways around them.

It’s the opposite of the idea that moving brain power away from back office functions and instead to services people find useful is a good thing. This is all a digression about why it would be nice to simplify the tax code, regardless of your political persuasion, or lack there of.. but as they say, every loophole has a constituency, so I won’t hold my breath and will just waste twenty minutes to claim my tax advantage in the mean time 🙂

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5 Responses

  1. This is a really helpful breakdown of how tax loss harvesting works. It’s one of those things we’ve never done because it seems intimidating or risky, not to mention at least seems like it would make tax time more complicated (as if that was possible!). Our general mindset is also not one of tax avoidance — we want to live in a place with good schools and libraries, after all! But we also totally understand the flipside. Rather than do a smart thing last week, we just sat on our investments with frowny faces, and put off calculating August’s totals until today. 🙂 Hope you guys are doing well!

    • The MC says:

      Tax loss harvesting is something I find distasteful as well on principle, but the tax savings are large enough that I was glad to do it. Like you I didn’t want to deal with the extra complexity either, deciding to write about it forced my hand, which is a nice side effect 🙂

  2. Good Life says:

    I learned something here! Thanks so much for the primer on this excellent strategy.

    • The MC says:

      Glad you found it useful. Maybe I’ll keep trying to mix in some useful information in between the posts about underpants gnomes and comics, just to keep things interesting 🙂

  3. I wouldn’t even be able to *blink* with a screaming baby, let alone tax harvest. 🙂

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