Everyone is busy this time of the year. We’re all hustling to buy gifts, stocking up on holiday dinner supplies, and planning ways to avoid our drunk uncle at the family gathering.

The more financially savvy and tax-minded among us have other less “joyful and triumphant” items on the “to-do” list, though.

I’m talking about contributing to your 401(k) or IRA, deferring bonuses, and transferring stock gains into various funds — all in an effort to shelter your income from federal taxes.

Let’s make one thing clear before we go any further:

At the risk of sounding like Scrooge, I will say that I think taxes are important (read: essential) to support necessary infrastructure — roads, bridges, police. They are part of our civic duty, and regardless of how much we may dislike them, they are a necessary evil.

With that being said, I also don’t believe there is anything wrong with efforts to legally reduce your tax bill. (Loopholes exist for a reason, right?)

There is a distinct difference between tax evasion and tax avoidance:

We at Pro Trader Today will never support strategies of tax evasion. It is incredibly illegal and immoral, and you should be ashamed of yourself if you take part in evasion activities.

Tax avoidance, however, is 100% legal. Tax avoidance abides by the regulations of the tax code and prevents you from paying more taxes than you truly owe.

The tax avoidance rules apply to every person and always have.

“Most people pay the minimum amount of tax they’re legally required to and not a penny more… [tax avoidance] is not ‘legal’, it’s just legal.”

— The Guardian writer David Mitchell, in response to British Secretary of State George Osborne’s alleged acts of tax evasion

“A tax deferred is a tax avoided.”

For our discussion today, that means tax-loss harvesting.

Tax-loss harvesting falls under the category of tax avoidance. For many investors, it’s the primary tool for offsetting taxes now and in the future.

Until about 2012, tax-loss harvesting was a strategy known only to incredibly wealthy investors and large corporations — think Goldman Sachs and Morgan Stanley.

Thanks to the Internet, the knowledge spread. Now every investor —no matter how small — can take advantage of the benefits.

Tax-loss harvesting involves selling stocks, bonds, and mutual funds that have lost value to help reduce taxes on capital gains from successful investments.

However, the true extent of the strategy’s benefits inherently depends on an individual’s tax bracket.

Here’s how it works…

Mortimer is in the 15% capital gains tax bracket. He has a long-term capital gain of $5,000 in Investment A and a long-term capital loss of $3,000 in Investment B.

If Mortimer sells his shares of the losing stock, he can offset the $5,000 gain with a $3,000 loss, meaning his net long-term gain on the sale of Investment A and Investment B is only $2,000, with a $300 federal capital gains tax.

If Mortimer did not harvest the loss, the tax on his $5,000 long-term gain would be $750. By partaking in tax-loss harvesting, Mortimer has just saved himself $450.

Using tax-loss harvesting to offset capital gains doesn’t actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. This strategy won’t restore your losses, but it will soften the blow.

Overall, it’s important to keep your long-term investing strategy ahead of any desire to lower taxes.

Losses should only be harvested from assets that have shown a history of depreciation, don’t align with your investment portfolio anymore, or were already on the chopping block to be sold.

Just because one (or a few) of your stocks is worth less than what you initially paid does not mean it is necessarily a valuable option for harvesting.

The Fine Print

There is a key to this law that states that you may only deduct a maximum of $3,000 in losses each year.

But…

Any losses over $3,000 will be carried over into subsequent years. So if you declare $12,000 losses with no gains, you may deduct $3,000 in each of the next four years.

Claiming losses allows you to deduct those losses against your income. By claiming these losses, you will be reducing taxes owed.

But don’t forget we’re talking about the IRS here, and with the IRS, nothing is ever that easy.

Enter: Wash Sales.

From the IRS’ Wash Sale Rule:

You cannot deduct losses from sales or trades of stock or securities in a wash sale unless the loss was incurred in the ordinary course of your business as a dealer in stock or securities. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:

1. Buy substantially identical stock or securities,
2. Acquire substantially identical stock or securities in a fully taxable trade,
3. Acquire a contract or option to buy substantially identical stock or securities, or
4. Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA.
5. If you sell stock and your spouse or a corporation you control buys substantially identical stock, you also have a wash sale.

If your loss was disallowed because of the wash sale rules, add the disallowed loss to the cost of the new stock or securities (except in (4) above). The result is your basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. Your holding period for the new stock or securities includes the holding period of the stock or securities sold.

Now, in English:

The wash rule was created by the IRS to prevent investors from reducing their capital gains through wash sales. So investors must wait 30 days between selling off losses and buying back the same fund or a “substantially identical” fund.

Actually, the wash sale period is 61 days — the day of the sale, the 30 days before, and the 30 days after.

For simplicity, let’s isolate our conversation to the 30 days after the date of sale.

The ambiguity in the wash rule arises in trying to define what “substantially identical” means. Where do those parameters begin and end?

Well, someone should figure it out, because any investor who violates the rules of the wash sale cannot claim the losses on the current year’s tax return. Those losses would be deferred to the following year or possibly prohibited entirely.

Hypothetically…

Warren buys 500 shares of Technology Co. #1 on August 1, 2000.

Technology Co. #1 stock crumbles, so Warren sells those shares at a loss of $3,000 on November 1, 2015.

On November 5, 2015, Warren decides to give Technology Co. #1 another shot. Again, he buys 500 shares for $5,000.

There are a few results of Warren’s actions:

Warren cannot deduct his $3,000 loss from the first play, because he bought his “replacement” shares within the 30-day window. The wash sale rule defers Warren’s $3,000 loss until he sells his second set of shares.

Warren’s $3,000 loss is added to the basis of his $5,000 replacement purchase. He cannot deduct his $3,000 now, but he can reap tax benefits later.

When you make a wash sale, your holding period for the replacement stock includes the original time period you held the stock you sold. This rule prevents you from converting a long-term loss into a short-term loss. Losses on short-term assets can offset short-term capital gains, which are taxed at ordinary rates — not at the lower long-term capital gains rates.

If Warren had instead replaced his stock with shares of Automobile Co. #1, the wash sale rules would not apply, because these two are not “substantially identical” and cannot be considered replacements, even though the purchase was made within 30 days.

Robots Save Christmas

“Most people look at tax-loss harvesting at the end of the year only, but this is a huge mistake,” says Chris Hardy, a certified financial planner with Paramount Investment Advisors in Atlanta.

Here’s the problem…

Traditionally, tax-loss harvesting is performed on an annual basis, usually towards the end of the year. There’s a reason for that.

The process is labor-intensive and time-consuming. Human advisors, handling hundreds of portfolios, can feasibly only handle harvesting once a year.

For the S&P last year, 34% of quarterly returns were negative. Of that 34%, over 80% occurred outside of the fourth quarter. This means human advisors miss around 80% of harvesting opportunities.

But that’s all about to change.

CNN Money estimates that by 2020, robo-advisors will be mainstream — managing about $2 trillion in the U.S. alone.

Just like autonomous cars don’t drink, text, or get tired, “robo-advisors” don’t need sleep, don’t get sick, and don’t have anything else to do besides advise your portfolio.

“Robo-advisors” have the potential to change the paradigm of tax avoidance strategies. Tax-loss harvesting programs are reliable and have the potential to make a significant impact on your after-tax portfolio.   

Robo-advisors are especially popular among millennials, whose portfolios are still in the wealth-generation phase. Robo-advisors are also more affordable. At Wealthfront, robo-advising services are free for portfolios of less than $10,000 in assets.

For more seasoned investors with more complex portfolio needs, the “one-size-fits-all” approach of robo-advising might not be the most beneficial. Maintaining wealth can be a more complex game than acquiring wealth.

A robo-advisor won’t know the name of your children or ask how your vacation went, and I think there’s still something to be said for the personal touch of a human advisor.

After all, your robo-advisor probably won’t be sending you a Christmas card.

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