If you you are far in enough in your FI journey that you have a taxable brokerage account, then you know the uncle Sam is going to want his cut every year.
Read on to learn how you can reduce your tax burden (and Uncle Sam’s take) with a simple paperwork swap method known as tax loss harvesting.
Simply put, Tax Loss Harvesting is a way to reduce your taxes owed (1) when the stock market is down and (2) you hold investments in a taxable brokerage account (ie. non-401K/403/IRA account).
Many of my fellow FIRE bloggers write about TLH. The Financial Samurai has scads of great material on TLH, as his FAT Fire/high annual expenses provide significant opportunities to use TLH to offset his high annual tax exposure. Physicianonfire even provides an excellent step by step guide on how to perform TLH.
Should you care about TLH?
Maybe, if you are far enough in your FI journey. Let’s briefly cover some basics to determine if TLH is right for you. I’ll even provide a case study to highlight its potential benefits to you.
One thing to keep in mind: many early retirement enthusiasts don’t have a brokerage account. They accumulate wealth through rental properties, side hustles, house hacking, frugal lifestyles, and/or tax advantaged accounts only.
Many people achieve FIRE while never even making enough to contribute to a taxable brokerage. If you aren’t maxing out 401K ($20,500 in 2022), HSA ($7,500), and IRAs (6,000) already, then stop reading this and keep working until you can max these out and start a brokerage account.
If you are still with me, congratulations! You either have high income, or are extraordinarily frugal – either being enviable paths to FI.
Case Study
The current 2022 bear market has been painful for many but provides a great a great vehicle to examine TLH.
Let’s suppose you have been contributing to a taxable brokerage account that is 100% invested with Vanguard VTSAX Total Stock Market Index. You choose to sell $50,000 of VTSAX (which you bought for $60K a year ago) and use the money to buy $50,000 of VOO. Vanguard VOO S&P 500 fund is similar in performance to VTSAX but different enough to avoid the IRS Wash rule. Your sell and buy investment is essentially cash neutral.
But on paper the $50K sale is a loss of $10,000 over your basis in VTSAX (the $60,000 price you bought the shares at).
You guessed it, we are going to use the $10,000 paper “loss” to offset some taxes.
How might that work?
To make that math easy, I’m going to use fictitious figures for ease of illustration.
Lets say at tax time in 2023 when its time to pay our 2022 taxes, we see
- We had gains/dividends of $2,000 from our VTSAX brokerage account
- We had a “Loss” of $10,000 from our sale of VTSAX when traded it for VOO
- Our top income tax rate is 22% for making a dual household income of $135K.
If we had NOT sold our VTSAX, we would have to pay capital gains taxes on $2000 in dividends we earned in our brokerage account and we would have had to pay taxes on $135K of income like normal.
But because we reported a $10,000 loss, we can apply that loss to the 15% tax we would owe on capital gains (in this example, just $2,000, but TLH has no limit on capital gains) and avoid paying the 22% tax rate on up to $3,000 (per year) on our earned income, which is $135K.
How much would that save us? It saved us being taxed on $5K of income ($2K capital gains and $3K income tax), which amounts to $960 less taxes owed in 2022 taxes: $300 dividend taxes avoided and $660 earned income taxes avoided.
What’s more, we only used $5,000 of the $10,000 loss on our 2022 tax bill, and we can carry over the leftover loss of $5,000 next year (and beyond if you have a large loss) to reduce the next year’s tax bill. Sweet! Assuming we make the same a year from now on income and dividends and the tax laws don’t change, our “paper shuffling” activity saved us $1920 over 2 years.
So is TLH for you?
Well, if you are FIRE adherent like me with annual expenses that stay below the $83,350 limit for a 0% capital gains tax rate; then TLH is extra paperwork for no gain in most years.
However if I have a year where I withdraw more, perhaps to invest in a rental property or perhaps to buy a sweet boat that sits parked in storage 11 months out of the year (just kidding), then TLH might help me lower my tax burden in those years.
TLH might be a regular consideration to lower your tax burden, however, if either of the following describes you:
- you still earn a full time income and have a taxable brokerage account
- you are retired and have high annual living expenses that require withdrawals of more than $83K in capital gains from your brokerage.
Will it have a major impact on achieving FI or early retirement?
In my view, for most people, probably not. $1920 in tax avoidance over 2 years is not enough money to shorten your time to FI, especially if you plan to achieve it in 15 years like I did.
Unless you have other non-brokerage income to offset (sales of rental property, etc.), its unlikely TLH is going to ring up large numbers, as you would need a significant brokerage nest egg generating huge dividends to offset before TLH would make a big difference.
For example, if you are still working and you have $1.2M in a brokerage account that generates $40K in annual dividends, TLH could save you, say, $6K in taxes on those dividends. That kind of money reinvested could be valuable over time. But if you already have $1.2M in brokerage, on top of 401Ks and other investments, I highly doubt you will need that $6K tax avoidance to reach FI because you are probably already FI.
Still, while I don’t believe TLH will be a major tool in your FI toolbox, if you manage your finances closely like I do, you won’t pass up an easy opportunity to save up some vacation money, a 529 fund for your children, or some other fun money.
TLH is not difficult to execute and is some of the easiest money you can earn for clicking a button on your computer during certain market conditions.
In the comments: Do you harvest your tax losses or are you planning to in 2022? If so, how much money did TLH save you? I’d love to hear your comments below.