How Medical Professionals Can Use Taxable Losses to Lock In Tax Advantages

As I sit to write this, I realize that I have not talked a lot about tax loss harvesting. This a the idea that most of us may be familiar with. It’s basically the idea of being able to use paper losses from our stock investing to create taxable losses for tax advantages. But we (I guess I will speak for all of us, but certainly I fit in this category) are likely to feel much less comfortable implementing these strategies even if we understand them.

So, I worked with key resource Doc2Doc Lending to create this post as a basic primer on the topic.

I hope you find this as helpful reading as I did writing it.

Setting the stage

As a medical professional working toward your financial goals, the pillars of your financial plan should include paying off debt along with investing, ideally in an allocation of low cost, broadly diversified index funds of stocks and bonds.

And, although markets fluctuate throughout the years, the long-term trends are typically up. That’s why we invest in the overall market for the long term rather than try to stock pick and time the market (which studies show underperforms the overall market 80% of the time). That also means, over time, you’re highly likely to experience appreciation and capital gains.

This is a good thing. However, from a tax perspective, many investors struggle to know what to do when their stocks appreciate, and will incur capital gains taxes upon sale. (The strategies below in this post will help you offset these gains when you do have to sell your stocks!) For some, the initial instinct might be to always sell off securities at a gain and hold onto ones that have lost value until they might swing up again. Others hold onto the gains, thinking they will continue to rise. And they sell ones that have gone down to avoid further losses.

Capital gains tax rates

Capital gains are taxed according to different tax brackets than income taxes. So it’s important to know where you sit on the capital gains tax bracket chart.

According to the IRS Capital Gains and Losses publication, the thresholds for households fall at:

$80,800 and below for a 0% rate
$80,800 to $501,600 for a 15% rate
And a 20% rate for any capital gains harvested above that $501,600 threshold.

Because the tax is progressive, it means that the first $80,800 of total income has a capital gains tax rate of 0%, regardless of whether one exceeds the threshold.

These rules and principles can confuse some who misinterpret that income and capital gains are the same bracket. Or that they don’t have any relation to each other.

While there is no additional tax on capital gains below $80,800, this doesn’t mean your gains are tax-free if there’s less than $80,800 in gains. It means they don’t get taxed if your total reported income is less than $80,800. It takes your income into account first, and then adds capital gains. Failing to recognize this could result in a hefty tax bill.

The ideal place to be is right at the top of a bracket, but not over. This leads to the lowest effective tax rate in relation to the marginal tax rates of each bracket.

Cost basis and holding periods

Notice how these taxes applied to long-term capital gains rather than short-term capital gains. That’s because long-term capital gains (gains on investments held for longer than one year) are taxed at different rates than short-term capital gains (gains on investments held for one year or less).

Short-term capital gains are taxed as regular income (typically your higher marginal rate). This means that an individual must hold onto their investments for more than a year to take advantage of the rules surrounding both capital gains and losses.

Capital gains and losses are calculated based on cost basis. Cost basis is typically the amount the investor paid to purchase the securities. To benefit and avoid penalties, it worthwhile calculating cost basis each tax year.

Taxable losses creating tax advantages

Though it may not be desirable from an investment perspective to incur losses, capital losses can carry a significant benefit to the taxpayer as a consolation. This is where tax loss harvesting (TLH in online forum parlance) and using capital losses for tax advantages comes into play.

When you record them accurately, capital losses can offset capital gains and even some ordinary income for certain taxpayers.

This has led to the TLH strategy: selling securities that have lost value to offset other taxable income and lower one’s total income tax obligations. After selling the stock (ideally index fund) with the loss, you buy another stock (ideally index fund) that is “not substantially identical.”

A case study

For instance, you own the VTSAX Vanguard total market index fund and the market goes down a bunch. You sell your VTSAX holdings to harvest the losses incurred and buy the same amount of VFINX Vanguard 500 index fund. You still are invested in the same amount in largely the overall U.S. stock market. And additionally, you’ve created tax advantages through your taxable losses.

So, in the end, you still hold the same asset allocation of investments in your portfolio. Meanwhile, you also “harvested” your tax losses to offset up to $3,000 of active income each year and an indefinite amount of capital gains each year.

But, make sure you do not repurchase the investment within thirty days, triggering a wash sale that invalidates the transaction.

Net capital losses also carry over into future years. If one has net capital losses and records them properly, they can claim them in subsequent years. This can offset capital gains and even up to $3,000 of ordinary income over time.

Of course, regardless of your financial situation, these strategies work best when paired with a Certified Public Accountant (CPA), wealth manager, or financial advisor (here are some I have used) who can walk you through the important details about how these all work in your specific situation.

Should you use taxable losses to create tax advantages?

Basically, should you tax loss harvest?

I’ll be honest. I have not yet tax loss harvested. Why? Well, because of an important caveat that I’ve so far skipped over. You can only TLH in a taxable account.

Since capital gains and losses aren’t created from transactions in a tax advantaged account, like a 401k or 403b or others here, you can’t tax loss harvest.

So far, the majority of my stock investments are in non-taxable accounts. Our taxable account remains small because we use a lot of those savings to invest in real estate instead.

However, when our taxable account gets big enough, I certainly plan to tax loss harvest. Why not use that $3,000 deduction of your ordinary income? This especially becomes advantageous if you anticipate a large capital gains event in the future, like the sale of a medical practice or something like that.

The biggest risk is a wash sale from buying a fund that is substantially identical, according to the IRS, to the one you just sold. If you TLH too much, you can risk running out of non-substantially identical funds to substitute in and out. So, TLH only when there is a real big drop in the market, not just a small dip.

Direct indexing is also a newer strategy with perhaps a greater potential to use tax loss harvesting. However, this is not a DIY endeavor like traditional TLH can be.

Regardless, these strategies are just another slick way to use taxable losses to create significant tax advantages.