Every year, the IRS allows for $3,000 of tax losses on securities. Any losses higher than $3,000 are rolled into later years.
But why would one want to have losses on their securities? We’re here to make money right? Well, some brilliant person many years ago realized that you could artificially have tax losses by buying and selling correlated pools of securities (ETFs, indexes, mutual funds).
I’m 25, and plan on being FI/RE by 35. As a conservative assumption, I’ll estimate I live to 100, as the people in my family are old, and no one has had cancer or disease, so crossing my fingers for me too! I’d then like to have 65 years worth of tax losses early on in my years, as they can always be rolled over to the next. Why? You always want to pay taxes later rather than now, because money today is worth more than it is in the future, because you can invest it. In addition, my tax rate will be lower when I retire, as I’ll earn less every year.
That’s 65*$3,000/yr = $195,000 in tax losses which seems like a lot. I plan on my family spending more than $75,900 (or the equivalent when I retire) every year, which means I’ll be paying 15 percent in Long Term Capital Gains tax (LTCG) every year. When your ordinary income is below the 15 percent tax rate, you pay $0 in LTCG tax! Unfortunately for me, I’ll be paying 15 percent in LTCG as my budget is more than the 15 percent ordinary income cap.
I plan on first maxing out my 401k, then maxing out my backdoor roth every year, and then putting my money in a roboadvisor until my taxable losses cap is met. I’m not interested in doing it manually as I don’t have a large taxable account yet.
These tax losses hinge on the IRS’s IRC Section 1091. The IRS states that you are not allowed to acquire “substantially similar” stock, security, or contract or option once you sell the security for a period of 30 days.
Selling Facebook (FB), but buying a call option on FB shares, even if out of the money? Not Allowed.
Selling the SP500, but buying SP500 futures? Not allowed.
Selling the Sp500, but buying the Russell 1000, which has a .99 correlation? Ok, according to the various corporations who have large groups of legal advisors. The IRS has not released a statement regarding this for 23 years.
The first issue at hand is the IRS code that defines the wash sale was created nearly a century ago, when ETFs and other pooled investments weren’t available for consumers to buy so easily. Nowadays, you have a lot of ETFs that don’t hold exactly the same investments but are very correlated with each other, with similar returns.
For example, the SP500 takes the largest 500 companies by market capitalization and rebalances quarterly. The Russell 1000 takes the largest 1,000 companies by market cap and rebalances yearly. The Russell 1000 is just the SP500 with the next 500 companies with biggest market cap. At a correlation of .99 (correlation goes from 0 to 1, with 1 being the most correlated — a correlation of .99 is incredibly high), the tracking error of switching one ETF out with another is incredibly small. So problem solved, switching ETFs of high correlation for tax losses.
Problem number 2 is that determining how to do this. In a perfect life where I have ample time to code, I’d put my trusty (not really) computers science skills to good use and create an algorithm that:
1). Sets up a database of ETFs that are similar to each other by correlation, but aren’t “substantially similar”. I’d sector the database into 3 segments, for an easy 3 fund portfolio. I’d argue the Sp500 has 500 stocks and the Russell 1000 has 1000. US Domestic Stocks – SP500, Russell 1000, etc. Set up one segment for international bonds and one for domestic bonds.
2). Have a script that runs every second, and based on the volatility of the stock, switch out ETFs for tax losses. If I have 5 similar ETFs by correlation in my database, you could argue I could swap out indexes every 6 days and have them rotate (30 days wash rule/5 indexes = 6 days per switch).
Now, I wouldn’t do this at all. A program like this would probably take me a few hundred hours. I don’t know which broker has an API that I can use to automatically trade in (maybe Internative Brokers?). I’m rusty on my programing, and am doubtful that the broker uses a language I’m readily familiar with. I’d have to find the historical data for ETF’s, and since I don’t have Bloomberg to do this for me easily, I’d have to do each one manually.
Doesn’t seem realistic for me, if someone else has already invented this program (roboadvisors), I’d rather just pay them to do it for me. The cost to pay them is cheaper than doing it myself.
Over the next 10 years, the max I could save is $15,000 on my losses. That’s $30,000 for total tax loss ($3,000*10 years) and let’s assume the max tax rate I could pay is 50 percent (depends on your state, but this is a back of the napkin calculation). After I retire, I’d only save 15 percent in LTCG for the rest of my life, so that’s $165,000*.15=$24,750 saved. Now, if you account for the present value of the money I’d save, I’ve calculated that to be $15,263 total.
This is assuming I can earn 7 percent annually on the money I’d save in taxes. The PV of the money I’d save from years 36-100 is $3.2k, which is only 20 percent of the total amount I’d save, but it costs $165k in taxable losses. Years 25-35 would save me $12k, which is 80 percent of the total savings! Sometimes the Pareto principle really applies. Maybe I’ll just put my money in a robo advisor until it gets to $30k in taxable losses, call it a day, and move it back to Vanguard.
You could manually harvest by having something online inform you whenever your index dropped below 1 percent of your cost basis, then sell (limit order) and buy a similar index (but I’m not aware of limit orders involving the index you’re not buying), but there are slippage concerns here — my ability to press a button across two webpages is probably a 1 second delay, and the market has the ability to move in that second. Also, I have trading fees that I need to cover. It wouldn’t be worthwhile for me to do this unless I had a substantial amount of money, so that the trading fees would be a small percentage of the tax loss harvested.
Since my time today is more valuable than my time tomorrow, as the money I make today can be invested now and grow, I’m going to just let the roboadvisor do the work for my taxable accounts.
The roboadvisor is best for people who have small taxable accounts. If you have a large amount in your taxable account, you should be doing this yourself, it’s way more cost efficient. I’m hoping to have all my taxable losses for my whole life accounted before I retire.
In my next post, I’ll come up with a spreadsheet to calculate if you should be using a roboadvisor or simply harvesting your tax losses manually, and when you should switch over from a roboadvisor to manually doing it (if you are willing to manually harvest).
Subscribe to get access to FREE spreadsheets to save money and the entire resource pack!
Olivia worked in finance and wants you to learn the secrets of financial independence. She’s on track to reach financial independence before 30, and she wants to teach you how you can retire in less than a decade as well.
She thinks everyone needs an emergency savings fund and uses CIT Bank . They have the highest yielding rate at 1.55% and only require a minimum of $100. No monthly fees or charges like other big banks!
Her favorite free investment plan is from Ellevest. Go to Ellvest and click “Get Started” to get yours.
Her favorite personal finance tool is Personal Capital, which allows her to track her spending, historical net worth, and monitor her credit cards. It’s an upgraded version of Mint, in her opinon.