The Tax Loss Harvesting Charitable Giving Tango

The Tax Loss Harvesting Charitable Giving Tango

When the Market Gives You Lemons, Harvest That Delicious Fruit!

When the market is having a bad month and pundits like Jim Cramer are trying to figure out how to “game” the pullback, FIRE bloggers start implementing their own version of gaming the system: tax loss harvesting.  Bloggers like the Mad Fientist and Physician on Fire have written great articles on tax loss harvesting.  The biggest downside to tax loss harvesting is increasing your future capital gains, but I’d like to share how those who give to charity can wash away those gains that they incur during tax loss harvesting.

Stocks are falling but, like him, they’ll bounce back up eventually…

The premise behind tax loss harvesting is to “harvest” the losses in a taxable account while maintaining your market position.  Remember, this is for TAXABLE accounts only.  You’ll only be gaming yourself if you try this in a 401k or IRA.  While there are many articles on the mechanics of tax loss harvesting, I’ll provide a quick summary to refresh your memory.

The trick to tax loss harvesting is to take an investment that has depreciated in value since you purchased it, sell it and immediately purchase a similar but NOT IDENTICAL investment.  Here’s a quick example of the way that this looks in practice:

  • Buy 100 shares of Vanguard Total Stock Market Index (VTSAX) at $70/share
  • VTSAX crashes to $35/share!!!!  Quick, run for the hills!  All you preppers out there, get your anti-zombie artillery ready…
  • Sell your shares of VTSAX at $35/share and IMMEDIATELY purchase the Vanguard Fortune 500 Index (VFIAX)

Now what did you just do?  You sold your shares of VTSAX, which locks in your losses of $3500.  Now this sounds like a dumb thing to do, but remember, you really just turned your shares of VTSAX into shares of VFIAX.  Now these are obviously not going to perform exactly the same, but they track each other really closely.  So, when the market climbs back up, your VFIAX shares follow and you get to ride the gain back up.  The IRS will let you use the losses to reduce your capital gains for the year and then use up to $3000 of your remaining “losses” to reduce your income for the current year.  The losses that you can’t use this year (over the $3000 limit) can be carried over into the future to offset your future income.

Ok, it’s a little more complicated than that… There is an IRS rule called the “wash sale” that invalidates any tax loss harvest if you buy substantially identical assets 30 days before or after a tax loss harvest.  This includes accounts like your IRA and even dividend reinvestment, so you need to make sure that you are not reinvesting dividends in your taxable accounts and that the funds you are using in your taxable accounts are different from your retirement accounts to avoid a wash sale.  You also should learn about the specific ID (SpecID) means of identifying specific shares so that you can harvest only the shares of a given fund that have losses.

So, why the brief foray into tax loss harvesting when the topic has been covered much more thoroughly by others?  Well, I really want to focus more on a specific strategy to deal with one of the drawbacks of tax loss harvesting.

The Drawback to Tax Loss Harvesting

The biggest downside to tax loss harvesting is that you are not actually avoiding taxes!  You are DEFERRING them.  Now, as a physician, I have intimate knowledge of delayed gratification, but this is delayed punishment!  If I reference the example up above, by tax loss harvesting, you reduced your income for this year by $3000 and carried the $500 loss forward for next year, thereby saving you from paying your marginal tax rate on that amount.  Now that you’re congratulating yourself on having found a legal “loophole”, you have to go back and look at your basis in your funds.  When you originally purchased VTSAX at $70/share, your basis in those 100 shares was $7000.  By performing the tax loss harvest, your basis is now $3500.  If those shares appreciate to $140/share by the time you actually decided to sell the fund (take the money and run), you would have owed taxes on $7000 in gains ($14000 current value – $7000 basis).  Now that you’ve done your fancy tax loss harvesting, you now owe taxes on $10500 ($14000 current value – $3500 basis).  Remember, when you did the harvest, you bought $3500 of VFIAX after selling VTSAX at $35/share so that reduced your basis.

When you tax loss harvested, you just created $3500 in future long term capital gains in order to reduce your current income by $3500.  If you are currently in the top tax bracket, that means that you saved $3500 x 0.396 = $1386.  If future tax rates on capital gains are the same as today, you’d pay anywhere from 0% to 20% tax on that $3500 when it comes time to sell the stock.  Assuming a 15% rate, you’d pay $525 in future taxes, so you gained $1386 today and lost $525 in the future for a total gain of $861 for your tax loss harvest.  This is still pretty good, but remember, if your current marginal tax rate is lower and future capital gains rate end up higher, you could end up with significantly less benefit.  Even in the worst case of low current income tax and higher future capital gains tax, when you consider the time value of money, this still probably works out in your favor.  However, if you currently give to charity in a significant way, I have a better deal for you!

It Takes Two to Tango or Washin’ Away Those Gains

This guy’s dancing, but I wouldn’t want to tango with him!

I started tithing long ago when I first met my wife and we have continued to increase our giving over time.  Until recently, I would just take a percentage out of each paycheck, give to our church and the organizations we support on an ongoing basis, and let the money that was not already earmarked build up in my savings until the end of the year.  Then I would donate it all at once to the other organizations that I wanted to support.  At tax time, I would claim my charitable deduction for the year and that was that.  But after learning about the Donor Advised Fund (DAF) from reading Physician on Fire, I came up with a better strategy.

One great thing about a DAF is that it allows you to easily donate stocks.  You donate stocks to the fund and the fund liquidates the stock without triggering a taxable event because it’s a non-profit.  Then you can have the fund send grants to the organizations that you would usually support.  This is so much easier than contacting each organization to try to get them to accept stocks or mutual funds directly.  The beauty of this is that you can now donate appreciated stocks and mutual funds to your church or other charitable groups.

So, the way I implement my strategy is that, instead of donating money directly to charity, I find my funds that have appreciated the most and then donate them to charity using the DAF.  I then immediately repurchase the funds with the cash that I would have otherwise given to charity.  This is what it looks like using the earlier example:

  • Buy 100 shares of Vanguard Total Stock Market Index (VTSAX) at $70/share, making your basis $7000
  • VTSAX crashes to $35/share, for a loss of $3500
  • Sell your shares of VTSAX at $35/share and IMMEDIATELY purchase the Vanguard Fortune 500 Index (VFIAX), now your basis is $3500
  • It’s been a good year, so at the end of the year, your shares of VFIAX are now worth $7000 again, so you have $3500 in gains
  • You were going to donate $7000 cash to Médecins Sans Frontières (MSF) at the end of the year, but this year you give your shares of VFIAX to your Donor Advised Fund and then send a $7000 grant to MSF from your DAF
  • Then you take the $7000 cash you would have donated and immediately repurchase shares of either VFIAX or your original VTSAX.
    • MSF has the $7000 you wanted to give them
    • Your basis in your fund has increased from $3500 to $7000, so you washed away the gains you incurred during your tax loss harvest
    • You still get to claim a $7000 charitable donation at tax time!

So there you have it!  You get the benefit of claiming a “loss” on paper that reduces your income taxes for the year, you get to wash away the gains from your harvest and you still get the charitable deduction on this year’s taxes.  Your charitable organization even gets the same donation that they would have if you had given them cash.  So tax loss harvesting and charitable donations dance a mighty fine tango together!

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