The math
Tax-loss harvesting mostly postpones tax.
When a fund falls, you can sell it at a loss and buy a similar fund. The loss cuts your tax this year. But the tax does not go away. Most of it comes back when you sell later.
What tax-loss harvesting is
You own a fund in a taxable account. The fund falls below the price that you paid. You sell the fund, and you realize a loss. On the same day, you buy a different fund with similar investments. Your market exposure stays almost the same, and you have a loss for your tax return.
The new fund must not be "substantially identical" to the old fund. If it is, the wash sale rule applies. The law disallows the loss if you buy substantially identical securities within 30 days before or after the sale. The disallowed loss goes into the basis of the new shares.
A capital loss first reduces your capital gains. If your losses are more than your gains, the IRS lets you deduct part of the difference from other income. The limit is the smaller of $3,000 or your net loss. The limit is $1,500 if you are married and file separately. You can carry the rest of the loss forward to later years.
Where the tax goes
The example uses round numbers. You invest $100,000. The fund falls 20% to $80,000. You harvest the $20,000 loss and buy a similar fund for $80,000.
Your cost basis is now $80,000, not $100,000. This change is the important part. Your later gain is $20,000 larger, so your later tax is larger too.
The tax saved now and the tax paid later
A $20,000 loss used against long-term gains at an assumed 15%
- Tax saved this year
- $3,000
- Decrease in cost basis
- $20,000
- Extra tax at a later sale
- $3,000
At equal rates, all of the $3,000 comes back when you sell. The harvest did not remove the tax. It moved the tax to a later year.
So the real value is time. You keep the $3,000 for many years, and that money can grow. The effect is the same as an interest-free loan from the government.
What the delay is worth
Our example makes four assumptions. Both paths grow 7% a year after the harvest. You invest the tax that you save in the same account. At the end, you sell everything. You pay 15% on the gains.
| Years held | No harvest, after tax | Harvest at 15% | As a share | Harvest at 32% | No sale, basis steps up |
|---|---|---|---|---|---|
| 1 | $87,760 | $178 | 0.2% | $3,781 | $3,210 |
| 5 | $110,374 | $1,027 | 0.9% | $5,590 | $4,208 |
| 10 | $148,766 | $2,466 | 1.7% | $8,661 | $5,901 |
| 20 | $278,139 | $7,318 | 2.6% | $19,011 | $11,609 |
| 30 | $532,633 | $16,861 | 3.2% | $39,371 | $22,837 |
Look at the 15% column first. The value increases with time, but slowly. After 20 years, the harvest adds $7,318. That is 2.6% of the final amount. It is real money, but it is not a large return.
When the harvest is worth more
You save at a high rate and pay at a low rate. Short-term gains have the tax rate of ordinary income. If the loss removes short-term gains at an assumed 32%, you save $6,400 now. Later, you pay back only $3,000 at the long-term rate. You keep the difference permanently.
You never sell. Inherited property gets a new basis. In general, IRS Publication 551 gives this basis as the fair market value at the date of death. Thus the postponed tax never comes back. In our example, the harvest then adds $11,609 after 20 years.
When the harvest costs you
| Years held | Save at 15%, pay at 24% | Save at 15%, spend the money |
|---|---|---|
| 1 | -$1,640 | -$3,000 |
| 5 | -$882 | -$3,000 |
| 10 | $405 | -$3,000 |
| 20 | $4,743 | -$3,000 |
You spend the money that you save. Then you borrow the money and pay it back later. When you sell, you pay $3,000 more tax. Your wealth at the end is $3,000 lower. You spent it earlier, so this is not a gain.
Your rate is higher when you sell. Suppose that you save at 15% and pay back at an assumed 24%. The harvest then loses $882 after five years. It reaches break-even only after 9 years.
An automatic purchase can cause a wash sale. A reinvested dividend can buy more of the old fund within the 30-day period. The law then disallows that part of the loss.
The new fund behaves differently. The replacement fund is similar, but it is not identical. Its return can be different from the return of the old fund.
What to do
Harvest large losses in a taxable account, and hold for a long time. Time is the source of most of the value.
Invest the tax that you save. If you spend it, the harvest does not increase your wealth.
Think about the two rates. The value is largest when the loss removes income at a high rate and the later gain has a low rate.
Let the investment decide, not the tax. Buy a replacement fund only if you want to hold it.
What this leaves out
The model does not include state tax, other federal taxes on investment income, or fund fees. It does not include changes to tax law. It shows one harvest. Each repeated harvest lowers your basis again, and the same logic applies to each one.
Sources
- 26 U.S. Code section 1091, Loss from wash sales of stock or securities, for the 30-day period and the basis of the new shares.
- IRS Topic No. 409, Capital gains and losses, for the limit on losses against other income and the carryover.
- IRS Publication 551, Basis of Assets, for the basis of inherited property.