If you are a longtime reader, you may have realized I’m pretty obsessed with minimizing taxes.
To me, increasing your savings rate by decreasing your taxes is one of the best ways to retire earlier because it doesn’t require you to earn more, spend less, sacrifice anything, or take on any additional risk.
As I described in the Retire Even Earlier post, reducing your taxes can have a huge impact on your ability to retire early.
In the example I gave in that article, the lab rat was able to reduce his short career from 11 years to just 9 years, simply by reducing his tax burden during his working years.
While the Retire Even Earlier article focused on utilizing tax-advantaged retirement accounts to lower taxes, today I’m going to discuss a powerful tax-reducing strategy that can be applied to your taxable accounts: tax-loss harvesting.
The basic idea behind tax-loss harvesting is that you sell investments that have decreased in value and then use the losses to decrease your income taxes.
Say you bought 1000 shares of VTSAX (Vanguard Total Stock Market Index) for $43 and then a few months later the price dropped to $40. Since your $43,000 investment is now worth $40,000, you have $3,000 worth of unrealized losses. If you decided to sell your shares and take the $3,000 loss, you can then use that loss to cancel out capital gains or lower your taxable income by a maximum of $3,000 per year (any losses in excess of $3,000 can be carried forward to future years).
You may be thinking, “Mad Fientist, you really are mad. Why are you telling me to buy high and sell low?”
Although I am suggesting you sell your investments at a loss, I’m not suggesting you stay out of the market after you sell.
In the simple example above, the best course of action would be to sell your shares of VTSAX for $40,000 and then use that money to immediately buy shares of an index fund that performs similarly to VTSAX but is different enough to not be considered a wash sale.
A wash sale is when you sell shares at a loss but buy substantially identical investments 30 days before or after the sale.
If in the example scenario, you sold your shares of VTSAX and then immediately bought more shares of VTSAX, the transaction would be considered a wash sale and you wouldn’t be able to use those losses to reduce your taxes.
Therefore, rather than immediately repurchasing shares of VTSAX, you should instead purchase shares of a fund that performs similarly but tracks a different index (even if two funds contain similar stocks, the fact that they track different indices should be sufficient enough to avoid a wash sale).
For example, maybe you could buy shares of VLCAX (Vanguard Large Cap Index) instead. That way, your money will still be invested and will still rise and fall in a similar manner but the transaction won’t be considered a wash sale.
Lab Rat Scenario
Let’s use the last 9 years of historical stock data to see how beneficial tax-loss harvesting would have been for the lab rat during his working years.
Assuming he only looks at his investments at the end of each year, here is what the adjusted prices of his VTSAX investment would look like.
You can see that the price rises during the first few years, so there are no tax-loss-harvesting opportunities here. In 2008, the price dropped a bit but the majority of his portfolio was bought for less than the 2008 price so it may not be worth the hassle to harvest a small amount of losses at this point.
When he checks his portfolio in December of 2008, however, he’ll be in for a shock! The value of his investments have decreased dramatically. Rather than get scared or upset by this, the lab rat is smart and seizes the opportunity to not only harvest his losses but to use those tax savings to invest more money while the market is down.
To harvest his losses, he decides to sell all of his shares in VTSAX and immediately use that money to buy shares of VLCAX. Based on the lab rat’s numbers in the Retire Even Earlier post, this sale would result in over $14,000 worth of losses.
Although VLCAX is a fine investment, he prefers VTSAX so after two months, he decides to sell all of his shares of VLCAX and use that money to repurchase shares of VTSAX. Since the market was still falling in early 2009, this generates an additional $800 worth of tax losses that he can add to the $14,000+ that he already harvested.
So with just a little bit of work and two months of being invested in VLCAX, the lab rat now has nearly $15,000 worth of losses that he can use to offset future capital gains or lower his taxable ordinary income.
Since his future long-term capital gains will be taxed at 0%, thanks to his low level of income in early retirement, it makes sense to use those loses to lower his ordinary taxable income while he’s still working.
In this scenario, that means the lab rat can lower his taxable income by $3,000 for the last 5 years he is employed! Since his marginal tax rate is 15%, that means he will be able to invest an extra $450 per year that would have otherwise been spent on taxes!
Transaction costs can obviously decrease the benefits of this strategy so I’d suggest only investing in funds that do not charge any transaction fees.
You can buy and sell Vanguard index funds without paying any fees and you can trade Vanguard ETFs for free with a Vanguard brokerage account so those are great options if you want to harvest your losses for tax purposes.
To avoid wash sales and to help make your record keeping easier, you may want to manually reinvest dividends in your taxable accounts. That way, you don’t have to worry about an automatic dividend reinvestment interfering with or complicating your tax-loss harvesting.
By simply harvesting your losses during your working years, using those losses to decrease the taxes on your ordinary income, investing those tax savings, and then happily enjoying your tax-free capital gains during early retirement, you can boost your savings rate and achieve financial independence earlier in life without much additional effort.
Are you a tax-loss harvester? If so, how much have you saved by harvesting your losses?