Former Microsoft boss Steve Ballmer has been making headlines after an independent ProPublica investigation revealed he secured over $100 million in tax savings over several years, bending the wash sale rule that limits tax loss harvesting.
Tax-loss harvesting remains a popular tax optimization strategy for high-income earners, especially those deep in equities. Armed with the right harvesting know-how, regular retail investors can reap the benefits of this tax optimization strategy.
However, this strategy can land taxpayers in hot water when improperly used. Recently, C-suite executives' excess use of tax skirting has again fallen under media scrutiny.
Ballmer's broker, Goldman Sachs, has acknowledged the findings and pledged to adjust its trading practices.
Yet well-heeled money managers aren't the only ones who can turn their losses around. With proper execution following legal guidelines, tax-loss harvesting is a legitimate means to lighten an individual's tax loads.
Simply put, tax-loss harvesting is a strategic financial maneuver used by investors to lighten their tax load at the end of the year.
By pruning their portfolios of a few underperforming stocks, investors can offset the taxable profits realized by other equities, lowering their overall tax bill. For instance, if Ford Motors declines in value, it can be sold to counterbalance the appreciation of Amazon, offsetting the capital gains tax liability linked to Amazon's performance.
By skillfully implementing tax-loss harvesting, investors can unlock substantial savings and increase their take-home investment income over the long term.
“Tax-loss harvesting can be a great strategy during market downturns in non-qualified accounts,” says David Berns, Financial Planner at Truadvice Wealth Management. “Take 2022… markets were down around 20%, and we were able to harvest losses for our clients and carry forward those losses indefinitely.”
Another advantage of doing tax-loss harvesting is you can use $3,000 against your ordinary income taxes each year,” Berns adds.
Academic studies referenced by the Financial Times show harvesting can add 1-2% per year in after-tax returns to a diversified equity portfolio and even boost bond portfolios.
“Harvesting does play a big role in optimizing a client's portfolio,” says Angela Dorsey, Founder and Financial Planner of Dorsey Wealth Management. “During 2022, there were great opportunities to do tax loss-harvesting that we haven't had in years.”
Yet other advisors debate whether the strategy is worth it for all investors, hastening to add it may pull focus away from bigger goals.
“Harvesting works, but for the mass affluent, it shouldn't be the primary strategy,” says Freeman Linde, CFP and Tax Planner at La Crosse Financial Planning. “Far too often, we get seduced by ‘saving taxes' and forget that paying taxes means we made money. Minimizing taxes is not the goal – maximizing after-tax returns is the goal. Harvesting is a factor but not the primary driver of long-term returns.”
All Washed Up
Investors must stay within the bounds of the game. The limits of loss harvesting are clearly defined by the Internal Revenue Service (IRS).
The rules against wash sales have been in place since 1921. The aim is to ensure investors really do sell their loss-making stocks. The restrictions prevent investors from simply selling one lot of stocks and replacing them with the same or nearly identical equities within 30 days.
For instance, if an investor buys 100 shares of Nexchange-traded fundslix and then sells them within 30 days, then buys back 100 Nexchange-traded fundslix shares within 30 days, the transaction would be considered a wash sale.
In Balmer's case, he sold shares in the dual-listed mining giants Shell and BHP, but on the same day bought back the exact amounts of the other class of the companies' shares. His huge deduction, therefore, was based on simply swapping out one class of the companies' stock for another.
Berns says investors must take care not to violate the regulation. “To avoid this IRS rule, we buy a like-kind security to keep their (clients) assets invested,” he says.
“In order to avoid wash sale rule violations, it is key to avoid selling and then buying a similar investment within 30 days,” says Dorsey. “To be safe, it is best to buy an investment that tracks different indexes. For example, IVV and SPY could be considered similar,” she adds, referring to two of the best exchange-traded funds for broad market exposure.
Other advisors see most similarly allocated exchange-traded funds as safe for repurchasing plays.
“The IRS generally grants a healthy leeway with regard to exchange-traded funds and the wash sale rule,” says Jonathan Bird, wealth advisor at Farnam Financial. “I can say in my ten years in financial services, I've never seen the IRS disallow a tax-loss harvest because two exchange-traded funds that an investor traded were so similar as to trigger a wash sale.”
While loss harvesting can put a dent in an investor's overall tax bill, it is not the only measure individuals can use to knock some numbers off the end of their tax bill.
Leveraging tax credits, contributing to retirement funds, claiming deductions, and optimizing income tax bracket filings all form a well-rounded tax strategy. Those with exceptional circumstances may require a personalized tax strategy through a tax accountant or financial advisor.
Josh is a financial expert with 15+ years on Wall Street as a senior market strategist and trader. Josh graduated from Cornell University with a business degree in Applied Economics and has held numerous U.S. and European securities licenses. In addition to running an investment and trading firm, Josh is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses himself.