Vieje back here again. Hope you all had a great Thanksgiving week. I didn’t get a chance to say it last week so I wanted to let you know how grateful I am for you all. Startups are tough and we all know it, but you all make writing this newsletter and serving the startup community well worth it. On behalf of Secfi, we appreciate you all!
I’m back this week with John to try something a bit different. We wanted to do a “conversation” style between us about what we’re focusing on, from a tax and investment perspective, at the end of the year. Because these are real conversations we’re having.
I’m a CPA, so I’m used to focusing on how to reduce your tax burden, while John’s background as an investment advisor is about protecting and growing your money.
These topics are especially relevant this year in a downmarket, and with the recent crypto situation.
Heads up that this is a bit of a longer one due to the format, but I’d love to hear your feedback. Would you like to see more of these? If so, on what topics?
Anyway, here we go:
🌽What’s this I keep hearing about tax-loss harvesting?
Vieje: Hey John, so what do you know about tax-loss harvesting?
John: Tax-loss harvesting is about realizing a loss on a position that you have in your investment account. So when it comes time to pay the tax man, you can offset any gains, or even offset some of your income, with the losses that were realized. So you turn your paper losses into actual losses. And that can offset your tax bill.
Vieje: But doesn’t that mean you’re sitting on cash?
John: Well, you don’t want to be out of the market, necessarily. It's probably appropriate to maintain your equity allocation, especially when stocks are down, so you don't miss out on a potential rebound. So you do need to replace what you sell with something similar to maintain that exposure.
Before we go any further, can you dive into the taxes a bit more?
Vieje: This strategy works because when you buy a stock, you're assigned what's called a cost basis. Let's say you decide to buy a share of Google for $50. That’s your “cost basis.” Later you sell the stock for $70. You have “realized a gain” of $20. And in the world of taxes, you aren’t taxed on gains until they are “realized.” So when you sell the stock, you have a $20 gain and you’re going to pay tax on that $20.
John: Right, that’s why you have to keep track of your basis per share.
Vieje: Right. Now, on the flip side, let's just say you bought stock for $50 and the share price went down to $20. You haven't sold anything, you have what's called an unrealized loss and therefore, you're not going to be able to use that loss to offset your taxes. Tax-loss harvesting is effectively selling in this situation. You start with an unrealized position, you have a potential loss of $30, and if you sell it, you’ve realized a $30 loss.
This is what's called a capital loss and a capital loss may be used to offset gains or even ordinary income down the road. Basically, you're going to have some winners in your portfolio, some losers, and the tax-loss harvesting focuses on selling the losers which minimizes your tax bill on your winners.
John: Yeah, it's really this silver lining to a down market or a losing position.
Vieje: I saw a tweet about this, but I think one way to think about it, it's like losing less, right? It's kind of a weird concept, but it works out nicely.
John: Right, nobody wants to lose but it’s a way to lose less.
Vieje: But enough on taxes, John. I'd love to talk about tax-loss harvesting and how it impacts your returns. And looking at investments from an after-tax perspective.
John: Real quick before I jump into that. I think it’s important to note that you get to carry forward your losses for the next year. So if next year the stock market does really, really well, and you have a bunch of gains, the fact that you realize losses this year will offset those gains next year and lower your tax bill. So it's not a use-it-or-lose-it situation.
Vieje: Yeah, good point. And it can carry forward indefinitely too.
🤷 What’s an investment advisor’s role in tax-loss harvesting?
John: I think a lot of folks have this misconception that a financial advisor is supposed to get you better returns. That's part of it. But really what a financial advisor is supposed to be doing is maximizing your after-tax wealth. That is different from maximizing your gross return. Tax-loss harvesting is one tool in the toolkit to do that.
So when we are managing folks' portfolios, whether they're a new client and we're transitioning them to our investment strategy, or they're an existing client and we're rebalancing their portfolio, we look for opportunities to harvest losses and minimize gains. Now, sometimes realizing a gain is worth it, but when I'm analyzing someone's portfolio and considering how to adjust it, I'm looking for as many opportunities as possible to realize losses such that they can get those tax benefits, which increases their after-tax wealth.
Vieje: It seems like it's really, really important that someone actually has a full comprehensive view of your portfolio, right? I have individual stocks on Robinhood that I like to trade. I have accounts at Secfi. I have Coinbase accounts, things like that. It's kind of taking a comprehensive view right?
John: Absolutely, yes. So you said earlier that you can offset your income with some of these losses. Well, the magnitude of that offset depends on what your income is. What is your marginal tax rate? That's going to make a difference in how valuable the harvesting of losses is.
Another example is if you are with a robo-advisor, the robo-advisor likely doesn't know about your income situation, and likely doesn't know about your other accounts either. So they're optimizing and doing tax-loss harvesting within the accounts that they see, but they're ignorant of the things that are happening elsewhere in your portfolio or income that you have. It's not the worst thing in the world, but it's not the best either.
Vieje: Do you think tax-loss harvesting is overlooked by many advisors, CPAs, etc. in your experience?
John: I think that tax-loss harvesting is the tip of the iceberg. If you're just going to a CPA to file your tax return, they're not advising you on what to do to minimize your taxes. They're just filing your return and telling you what you owe. So you may be missing opportunities if you're not consulting with an expert on this.
The other thing that I see often neglected is a really coherent and intentional asset location strategy. What I mean by that is, locating certain asset classes or investment vehicles in certain accounts that have different tax treatment.
Some asset classes and vehicles are more tax efficient than others and vice-versa. The less tax efficient stuff should be located in the most tax efficient accounts. And the most tax efficient stuff should be located in the taxable accounts. So it's not just about tax-loss harvesting. That's just one tool that we use and that anyone should use to maximize after-tax wealth, but it goes way beyond that.
Vieje: I know a lot of investors — new investors, maybe — who have learned their craft through Robinhood in the last few years and they know about tax-loss harvesting. They’ve heard about it, but many don't really act on it, right? They don't think it makes a major impact.
John: I think that sort of attitude is one that is pretty detrimental to building wealth. This game is about compounding. Look at the difference between a 7% compound return over 30 years and an 8% compound return over 30 years. It's one percentage point. Doesn't sound like that much, but why not pick up every basis point you can? If you do that math in a spreadsheet right now, I guarantee you'll see a dramatic difference in the ending value of your wealth.
You end up with 32% more wealth if you make 8% per year versus 7% per year. A one percentage point difference. So these little things, they add up and they compound over time. You should be doing them every year.
🧼 Watch out for the wash sale rule (and how to get around it)
Vieje: I think we'd be remiss not to mention something called wash sales when it comes to tax-loss harvesting, right?
Vieje: But what is a wash sale? IRC 1091 in the tax code is the wash sale rule. And it prevents you from what's called a wash sale, which is selling the stock at a loss if you also bought the same stock within 30 days.
Say I bought Google stock on October 1st, and I sold a previous position at a loss on October 15th. That's within 30 days. The rule will effectively disallow that loss. It's saying I'm not allowed to take that loss because it's a wash sale. The rule extends 30 days before the sale of that loss and 30 days after. So it's a 61 day period where you cannot buy that same exact stock or else the IRS will determine it as a disallowed loss.
People may think that, hey, I have Google stock at a loss, I could just sell it and buy it back the next day. Well, no, that's a wash sale and the IRS will disallow that loss.
But John, I know you employ a few methods to kind of navigate around these wash sale rules besides just waiting out the 60-day period. Can you talk a little bit about that?
John: So in our client portfolios, we often use ETFs as a wrapper for the investment strategies that we're pursuing. We can sell an ETF and harvest the loss on that position. And we can replace it the same day with a different ETF. So it's not subject to the wash sale rule if it is different enough and the precedent here allows you to get pretty close to the similar economic exposure, as long as you're using a different ETF.
Here’s a topical example for folks that have a lot of big tech names in their portfolio. A lot of big tech is down quite significantly this year. There are ETFs out there that are fairly concentrated in some of these big tech names. So what you could potentially do if you have positions in Google, Apple, Amazon, Facebook, Meta, Netflix, etc., is sell those single name positions. And on the same day buy an ETF that contains those stocks in a large weighting and end up roughly in the same position with the same exposure but not be subject to the wash sale prohibition.
🔑 OK, let’s talk crypto…
Vieje: John, maybe we can jump over to probably something that every reader probably has in their portfolios right now, which is crypto losses. Do you have any crypto losses?
John: I do have some crypto losses. I harvested them earlier this year. And it's really interesting, because the crypto space is so new, and there's not a lot of precedent and regulations and rules yet. One thing that's interesting about crypto is that wash sales don't apply.
That whole complex 30-day buffer before and after, it’s not a thing for crypto — at least, not yet. And therefore, if you want to maintain your exposure to crypto, you can sell it and buy it back and get credit for those losses.
Vieje, I know you probably have some crypto losses too. How are you dealing with it?
Vieje: Unfortunately, quite a bit of losses this year… the cost of playing in web3.
I'll make this crystal clear. No one knows what to do with crypto and how to tax it. What the IRS came out with was, “OK, we're going to treat crypto as property for now.” And that's an easy cop out, because it's another way to say, “I have no idea.”
There's no wash sale rules with property. Only on securities. As it stands right now, if crypto is a property, there's no wash sale rule.
So, I'm going to harvest those losses. And I'm going to legally buy them back the next day, and hopefully, get some capital losses to offset some of those gains. And there's nothing that says that's wrong right now. I'm also weighing the transaction costs of doing that, of course.
I will caveat all of this by saying that this is in the view of the IRS right now. Maybe they’ll change the rule tomorrow. I'd imagine that something will happen eventually because there's going to be a lot of people taking advantage of it this year.
So last question, John. I'd love to hear how you're dealing with clients' portfolios this year, especially in the bear market we're in.
John: Yeah, for folks that have been with us for a little bit, we've been tax-loss harvesting. For new clients that are coming in, as we receive their portfolios on our platform, I'm looking across their positions, analyzing them, and transitioning their accounts to the strategy we want to pursue with a mind towards the tax impact.
Frankly, most of the time, I'm realizing some losses for these people. So they are not only getting what I believe to be a better-situated portfolio for them going forward, but they're also harvesting some losses, which will offset their income and/or future gains.
Outside of the portfolio is the tax location strategy. We're very conscious of the tax efficiency of different asset classes, and we do strategically locate those asset classes in different accounts for our clients.
And then the third thing that we're doing outside of portfolios is really tax planning, both figuring out how much they're likely to owe, but also taking a look at those with stock options and seeing if there are opportunities to exercise, because a lot of startups have lowered their 409A valuations, or their fair market values.
That could present an opportunity to exercise with a lower tax bill than you could have gotten earlier in the year before the valuation was lowered.
Vieje: Makes sense. I’m glad I hired you to do this for me this year. Honestly, I dreaded doing all the year-end planning… you’ve earned my fee!
Things we’re digging:
- ⚽ Think this World Cup is crazy?
- 🦄 The unicorn phenomenon. Pretty interesting research on the characteristics of a tech unicorn.
- 😞 These continue to be tough times in tech. I shared some thoughts with The Street on how you can think about your equity if you’re laid off.
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