Ep # 57: The Tax Benefits Of Investment Losses

Benjamin Haas |
  • What is tax loss harvesting and what type of accounts does it affect? - 1:33
  • Why is it important? - 3:36
  • When is a good time to review investments? - 5:36
  • How much can you deduct? - 6:32
  • Our role in the process. - 10:22
  • Proposed changes with the capital gains rate. - 12:29
  • Why it's good to claim losses. - 13:47
  • What is the wash sale rule? - 15:47



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Full Transcript:

Benjamin Haas  00:03

Hi everyone and welcome to A/B Conversations where we will help you CFP your way out of it. A podcast where you get into the minds of a couple Certified Financial Planners on how we think and feel about everyday financial planning questions and what should really matter most to you. A healthier financial life starts...now! Hey Adam, welcome back.


Adam Werner  00:30

Thanks for having me back. I know one of these days you're just going to do this on your own.


Benjamin Haas  00:34

No, I wouldn't do it without you. I'd have to change the whole title and everything. So a question for you for all our listeners. Do you consider yourself to be a competitive person?


Adam Werner  00:46

It really depends but I guess to answer your question, simply, yes.


Benjamin Haas  00:52

Yeah, so do you hate losing?


Adam Werner  00:56

It's not the best.


Benjamin Haas  00:58

So you don't like admitting when you've lost? Serious question.


Adam Werner  01:03

That's not necessarily true. I lose a lot.


Benjamin Haas  01:06

Okay, well, today we're going to talk about losing.


Adam Werner  01:10

Oh my God, I knew what the topic was. I still had no idea where the heck you were going.


Benjamin Haas  01:16

I try to tee these up, wonderful segues. Sometimes when we invest, things do not work out and I think it's really a good topic today. I'll let you maybe introduce it. When taking tax losses, really is the right thing to do.


Adam Werner  01:34

And it's something that I think maybe some people haven't heard of or really considered what it means. And when we use the term tax loss harvesting. Share what the heck does that even mean? And we'll be specific here. So in order to deduct or use a loss in your investments, it has to be outside of a retirement account. So it has to be what we would consider a non-retirement investment account. Otherwise, within an IRA, within a Roth IRA, within a 401k, whether you make or lose money, the IRS doesn't care, they're only going to tax you based off of what you take out. So different here, we're only talking about non-retirement investments.


Benjamin Haas  02:20

So that's a really important clarification to make because I think most people that we would meet and this is probably true, just people in general, you build your wealth when it comes to investments really inside retirement accounts. Granted, there are many other ways to invest and that's what we're talking about here. I would also make the point to your comment that theme of harvesting really does mean making the choice to sell something.


Adam Werner  02:48

Yeah, so when we say tax loss harvesting, that is an investment that you made, pick a mutual fund, pick a stock, it doesn't matter. So you bought it for $10,000, it's now worth $8,000, there is an unrealized loss. You don't realize that loss until you actually sell whatever that investment is and then based off of your gain or your loss, that's when the tax side of things kick in when it comes to these non-retirement investment accounts. If you have a loss, you can harvest that loss and now either use it to offset other investment gains or you can deduct up to $3,000 of those losses on your tax return in any given year.


Benjamin Haas  03:36

Yeah, so here's why it's so important and to use your words, this may not be something that people know a lot about or would come to us and say, do some tax loss harvesting for me. Is a really, really important financial planner thing for us to pay attention to this time of year and say to certain clients, hey, we have these gains, you're going to end up paying taxes on them or these other positions that maybe didn't do as well diversification, right? Usually, when one thing goes up, another thing may go down. Is it a responsible thing to claim a loss to offset those gains? Sure. Or I go back to March of 2020 when the market was really falling. You never want to feel like you're selling something at a loss but really, if in that situation, the market was down, we were able to take a loss and buy a parallel thing. We were able to then use those losses on a tax return, take advantage of the fact that values were down and really not put yourself in a spot where you were out of the market if we bought a parallel thing that then was able to be a part of the recovery in April, May, June and so on.


Adam Werner  04:48

So I think that is the key part. It is making lemonade out of these lemons that if you have losses, it's not necessarily just selling that investment to take the loss. And now you're sitting in cash until you have to, at some point, if you want to stay invested and grow your money, you're going to have to buy something again. It really is these two parts of the process, it's selling what you have at a loss and then buying something similar at that same time to hopefully, if and when the market does rebound in short order, which is what we've seen happen in the past few years; these drawdowns do not last very long. So that you're not necessarily just sitting on the sidelines in cash. Now you took the tax loss, great, but now you missed out on some of that potential growth.


Benjamin Haas  05:36

So two things and peeling back the curtain, it's not just the end of the year because that's usually, I mean, we're in the middle of it. That's why we're having this podcast today because it's triggering for us. Let's look at what these investments have either gained or what these mutual fund companies are saying they're going to kick off and see if there's anything we need to do proactively. But also at times of market fluctuation is another time for us to do that. So that's a clarification. The second thing I wanted to say to piggyback off of what you said, it's philosophically our belief about the different investment choices that are out there. When we say buy something similar, if there are more than 1,000 different large cap mutual funds, the difference between a fund that you own today and the next best thing, as far as we're concerned, it's really not all that different. But the action has to be there to claim the loss on the one and start a new cost basis, a new starting point. With another investment, we have to trigger that and that's our job.


Adam Werner  06:33

One other clarification, did you throw out the number of $3,000? You did. Great job. Fantastic. So in any given tax year, you can only deduct up to $3,000 of those losses. So in a scenario where you have more than $3,000, if you don't have the gains to offset whatever those losses are, you can only deduct up to $3,000. The good news is you can carry forward any of that excess to the next tax year and if you have another $3,000, and you still have more to deduct, you can kick that can down the road in perpetuity. It's called a capital loss carry forward. So essentially, they don't necessarily go to waste. It's just a matter of what other gains can you use to or what other games do you have in the future that you can use these losses to offset or you just continue to deduct that $3,000 until your losses are exhausted.


Benjamin Haas  07:33

So strategically, I want to be clear and maybe it's, you know why I started with a very corny question to you. I think it's always good to claim losses because at some point we are hoping one of the negatives of making money and having your investments make money is that there's going to be taxes owed. But if we've done a good job claiming losses when they occur, you can offset and I know you use that word and I just want to harp on that, you can offset the gains with any number of losses, not just $3,000. Get yourself to zero, it's just after that zero, we can't put more than $3,000 on the tax return but take the losses when you have them always because then they can offset gains in a future year, even if you can't claim them this year.


Adam Werner  08:19

So that leads me to another thought which is at this point, after the last few years have been pretty good in the stock market that there may not be those investment losses to take. So there are different ways that investments can kick off income to you as the investor: dividends.


Benjamin Haas  08:45

Even if you don't do anything. I think that's where you're going.


Adam Werner  08:47

Yeah, you're just owning whatever that investment is or you're just owning that mutual fund, there are usually dividends and even more confusing, there's something called a capital gains distribution that again, you can't necessarily control and that's just a function of the mutual fund that you own. The buying and selling that happens by that portfolio manager, their gains get passed on to you as the investor and that usually happens towards the end of the year as they look at this on a calendar year basis. Where did we fall and if we have these gains that the fund realized we now are forced to pass those on to you as the investor and you then would pay taxes on that as if it was income. So what we would hate to see is you have an investment that has probably grown over the last few years but it's that snowball rolling down the hill. You have an investment that has grown, it's continuing to kick off income in some way, shape, or form, right dividends or these capital gains distributions and you're reinvesting in that same fund. So now next year, you own a little bit more and it does it again and now you're paying taxes as you go. We can quickly see that spiral for some of our clients where it becomes a much bigger problem in the future where now they're paying taxes on income that they're not actually feeling on an annual basis.


Benjamin Haas  10:22

Yeah, and I guess going back to your initial point, if we don't have losses to offset that, you have to accept it but I guess the point that you're getting at is, then maybe we need to think as planners in the future, if we don't have losses, let's not compound that problem even more or let's find a different vehicle, different investment, that may give you a similar risk and return profile that does so more efficiently. And I guess we don't need to go into the differences between mutual funds and exchange traded funds today but I think that's to your point. It does all just roll back into what is our role for you. If you have these non-retirement accounts, every year it's just to assess this and if we know what's coming, then we can maybe plan a little bit more ahead for are we reinvesting this? Are we not? Do we sell the fund ahead of time, don't we? There's just a whole little bit of analysis to go into this.


Adam Werner  11:15

Yeah, and I guess it's one of those problems, that it's a good problem to have. You've invested money and it's grown so that's a good thing but now what's the most efficient way that we have to deal with these taxes? Is there another path that we can go down that at least limits that impact and actually keeps maybe more in your pocket moving forward? And just a quick note on those capital gains distributions, typically, they're not surprises. They don't just, hey, here's your distribution. They do put out an estimate usually a month or two in advance, so you kind of get a feel for what is coming down the road. Like we said, oftentimes, if you already own it and you have an unrealized gain, it's that really tough decision between am I going to sell this to avoid some short-term tax, by the way, if I sell it, and I have a gain, I'm going to pay tax anyway. There is that push and pull on, you're going to owe taxes in some way, shape, or form but sometimes it is just a conscious decision of well, maybe I'm okay taking this and doing something different that is more tax efficient moving forward. It really is situational.


Benjamin Haas  12:29

Yeah. I think that would be on us to help each other through that but there could be a scenario and I don't want to dig too deep in the weeds here. But there could be a scenario parallel to what you just mentioned that you bought a fund and it's done very well in the past but by the time you bought it and the time it's going to make its first distribution, you have a loss, but they're also going to pay you all these gains that you never really were participating in. So, there's a no brainer situation we're selling, it would make sense but I think some of this is going to come up at the end of the year for us too as we get some clarity or maybe don't get clarity on tax laws. I know we did a podcast on the Biden tax proposals couple months ago but there is some conversation around will that capital gains rate be changing this year. While the thresholds for the people that may in the current proposal effect, it is not going to be the masses. It's going to be important for us to assess that for a certain segment of our clients too.  It's a hot topic right now.


Adam Werner  13:29

Yes, I can't believe that. That is a couple of months ago and earlier this week, Biden made his presentation, gave some updates on that but yeah, at this point, it is still in the proposal phase. So yes, we're waiting to see what that looks like for next year.


Benjamin Haas  13:47

So I had two more notes on this. First, it's to understand how your investments and losses in gains may play a role in what you gift or what happens when you pass away. So again, being very specific to these non-retirement accounts. If you have losses, I'll go back to my comment. It's always good to claim them because if you pass away with a position that had a loss and now let's just say your children inherit that, there's what's called a step up in basis where their ability to sell it at a loss on the day that they inherited it, that's gone. So loss property, loss investments are never good gifts. They're always good for you to claim - gifts, whether you're doing that while you're alive or through your estate.


Adam Werner  14:36

Yes. So that's a great clarification. I'll take the flip side of that which is, if you are charitably inclined and do gifting throughout the year or whatever the case may be. A great way to avoid some taxes on investments that have a gain is to gift directly those either shares of stock, shares of mutual funds, whatever that may look like, you give those directly to the charity, as long as they are set up to receive them and then essentially whatever that gain is, you're avoiding the taxes on that. As far as your taxes are concerned, you're making a donation to charity for that value of whatever the shares of stock or mutual fund that you are gifting. The charity in turn, will turn around and sell that investment and whatever gains are in there, it doesn't matter because the charities by their nature are non-profits and will not pay taxes on those gains.


Benjamin Haas  15:38

Yep. Well said, I have one more completely unrelated thing or did you have something else to note on that?


Adam Werner  15:45

No, go ahead.


Benjamin Haas  15:47

Alright, so let's create the scenario where you have this investment that has lost a little money but you love it. You love it, you don't want to get rid of it. You want to hold it; you still believe in it long-term. We have to be careful because if you sell something at a loss for tax purposes, you're not allowed to buy it back for 30 days and if you do that's considered, I believe they call it the wash sale rule which basically says that you're going to owe taxes anyway.


Adam Werner  16:19

Yeah, yes. That's essentially the way the IRS closed that loophole of you selling an investment for a loss, buying the exact same investment immediately after or to your point within 30 days just for tax purposes. So that's where you were saying earlier, buying something structurally similar or even just similar in nature but it can't be identical because the IRS isn't as dumb as sometimes as we hope they are. They closed that loophole. So yes, that's a good point.


Benjamin Haas  16:55

Yeah, and I think that's probably more sensitivity for those that hold stock because they really believe in that company, you bought Apple at the wrong time, before earnings, whatever and now it's at a loss, you sell it. You can buy something parallel but you're not buying Apple for up to 30 days and you have to be okay with that period. That's very different than our suggestion that you sell this mutual fund that looks like a duck, talks like a duck, walks like a duck. This other investment over here looks and acts the complete same. So that's just a little bit of a different situation but I did not want to forget to talk about the wash sale rule.


Adam Werner  17:31

Yes. Good call.


Benjamin Haas  17:34

What else?


Adam Werner  17:36

I'm good.


Benjamin Haas  17:39

Hey, I think we won at describing tax losses. What do you think?


Adam Werner  17:44

I agree, we nailed it. The point is, if you have losses, don't let them go to waste. At the very least, let's have the conversation to make sure that yes, if there is a loss taking it makes sense and then what do you do from there. To your original point, use the losses when you have them, don't let them go to waste. You can't pass them on. The IRS would love for you not to take advantage of this legal loophole of taking your tax losses and deducting them.


Benjamin Haas  18:19

Yeah, and all joking aside, I know psychologically, we even talk about this when it comes to, you know, certain relationships that we have, hey, people worry about losses more than they feel the reward of gains. You don't want to admit a loss and you don't want to have to sell investments at a loss. We inherently tell people don't do that but when it does come to taxes, it's okay. It really is okay. In fact, it seems like the efficient thing to do. Harvest those losses. All right.


Adam Werner  18:50

Thank you.


Benjamin Haas  18:51

Until next time. Hey everyone, Adam and I really appreciate you tuning in. Please note that the opinions we voiced in the show are for general information only and are not intended to provide specific recommendations for any individual. To determine which strategies or investments may be most appropriate for you, consult with your attorney, your accountant or financial advisor or tax advisor prior to making any decisions or investing. Thanks for listening!

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