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Nobody likes losing money during a falling stock market.
But, when markets decline it's what you do next that matters most. That's where tax-loss harvesting can turn lemons into lemonade.
Tax-loss harvesting is a strategy used by investors to reduce their tax liability by selling investments that have declined in value and realizing losses.
The losses are then used to offset capital gains and can be used to reduce taxable ordinary income up to $3,000 per year. This strategy has gained popularity among investors as a way to minimize taxes and increase after-tax returns.
As an investor, taxes can significantly impact your returns. Taxes can eat up a large portion of your investment gains, especially in a year where there are high capital gains.
Therefore, it's crucial to have a tax-efficient investment strategy, and tax loss harvesting can be an effective way to achieve this.
In this article, we'll explore how tax loss harvesting works, its benefits and limitations, and when it makes sense to use it as part of your investment strategy.
Understanding Capital Gains and Losses
Before delving into the details of tax loss harvesting, it's essential to understand capital gains and losses.
Capital gains and losses refer to the difference between the purchase price of an asset and the sale price. If the sale price is higher than the purchase price, it's called a capital gain, and if the sale price is lower than the purchase price, it's called a capital loss.
Capital gains and losses have tax implications in taxable brokerage and trust accounts. Capital gains are taxable, and the amount of tax you pay depends on how long you've held the asset. Short-term gains are gains from the sale of assets held for one year or less and are taxed as ordinary income. Long-term gains, on the other hand, are gains from the sale of assets held for more than one year and are taxed at a lower rate than short-term gains.
Capital losses can also reduce your tax liability. If you realize a capital loss by selling an asset for less than its purchase price, you can use that loss to offset capital gains. If your capital losses exceed your capital gains, you can use the excess loss to reduce your taxable income, up to a certain limit.
Overview of Tax-Loss Harvesting
Tax loss harvesting is a strategy that involves selling investments with losses to offset capital gains and reduce taxes. The key is to sell investments that have lost value and then reinvest the proceeds in similar assets to maintain your desired asset allocation. By doing so, you can reduce your tax liability without significantly altering your investment strategy.
To identify investments with losses, you'll need to review your portfolio and determine which investments have declined in value since you purchased them. You'll also need to consider the tax implications of selling those investments. It's essential to understand the IRS's wash sale rule, which prohibits you from claiming a loss on a security if you purchase a "substantially identical" security within 30 days before or after the sale.
Once you've identified investments with losses, you can sell them to realize the losses. The losses can then be used to offset capital gains, reducing your tax liability. If your capital losses exceed your capital gains, you can use the excess loss to reduce your taxable income, up to a certain limit.
After realizing losses, you'll need to reinvest the proceeds in similar assets to maintain your desired asset allocation. For example, if you sold shares of a stock fund, you may reinvest the proceeds in another stock fund with similar characteristics. It's essential to be careful not to violate the wash sale rule when reinvesting the proceeds.
Overall, tax loss harvesting can significantly reduce your tax liability without significantly altering your investment strategy. By identifying investments with losses, realizing those losses, and reinvesting in similar assets, you can minimize your tax burden and increase your after-tax returns. It's a powerful tool for investors to consider when developing a tax-efficient investment strategy.
Potential Benefits of Tax-Loss Harvesting
There are several potential benefits to tax-loss harvesting which can be summarized as follows:
1. Capital gains tax reduction: Tax loss harvesting allows you to offset capital gains taxes on other investments. The losses you realize can be used to offset any capital gains you may have from other investments, reducing your overall taxable gains.
2. Ordinary income tax reduction: Tax loss harvesting can also be used to reduce your taxable income, as you can use up to $3,000 of capital losses to offset ordinary income in a given tax year. Any losses that exceed $3,000 can be carried forward to future tax years.
3. Portfolio optimization: Tax loss harvesting can also be used to optimize your investment portfolio. By selling securities at a loss, you can reinvest the proceeds in other investments to better diversify your holdings.
Tax-Loss Harvesting Example:
So how does Tax-Loss harvesting actually work in action? Here are a couple of hypothetical examples.
Tax-Loss Harvesting Example 1:
Mary purchased 100 shares of XYZ Company for $10,000 in January of 2021. By December of 2021, the value of those shares had dropped to $8,000. If Mary sells those shares, she will realize a $2,000 loss.
Mary could use tax loss harvesting by selling those shares and using the loss to offset gains in other areas of her portfolio. For example, if Mary sold another stock earlier in the year and realized a $2,000 gain, she could use the loss from selling the XYZ shares to offset that gain and reduce her overall tax liability.
However, the wash sale rule would prohibit Mary from buying back the same or a substantially identical stock within 30 days of the sale. Therefore, Mary would need to reinvest the proceeds from the sale of XYZ shares in a different, but similar, stock or wait at least 30 days before repurchasing XYZ shares.
If Mary wanted to maintain her exposure to the same industry as XYZ Company, she could consider purchasing shares of a similar company, such as ABC Company, within the same industry. This way, she can still benefit from the potential growth of the industry while avoiding the wash sale rule.
Tax-Loss Harvesting Example 2:
Let's say you have two investments in your portfolio: Investment A and Investment B. Investment A has increased in value since you bought it and you plan to sell it soon, which will result in a capital gain of $5,000. Investment B, on the other hand, has decreased in value since you bought it and is now worth $4,000 less than what you paid for it.
Without tax loss harvesting, you would owe capital gains tax on the $5,000 gain from Investment A. However, by using tax loss harvesting, you can sell Investment B and realize a $4,000 loss, which can be used to offset the capital gain from Investment A.
In this scenario, you would owe capital gains tax on the net gain of $1,000 ($5,000 - $4,000), rather than on the full $5,000 gain from Investment A. Additionally, you could use up to $3,000 of the capital loss from Investment B to offset ordinary income in the current tax year, reducing your overall taxable income.
Any unused capital losses can be carried forward to future tax years. So, in this scenario, you could carry forward the remaining $1,000 capital loss from Investment B to offset future capital gains or ordinary income in future tax years.
Limitations of Tax-Loss Harvesting
While tax loss harvesting can be an effective tax strategy, it's important to understand its limitations. The IRS has rules and restrictions regarding tax loss harvesting that investors need to be aware of. These rules are designed to prevent investors from using tax loss harvesting to evade taxes.
One of the main restrictions is the wash sale rule. As mentioned earlier, this rule prohibits investors from claiming a loss on a security if they purchase a "substantially identical" security within 30 days before or after the sale. This rule is designed to prevent investors from selling an investment to realize a loss and then buying the same investment back at a lower price, effectively avoiding taxes.
Another limitation of tax loss harvesting is its impact on long-term investment strategy. Tax loss harvesting can be an effective strategy for reducing taxes in the short term, but it may not be beneficial in the long term. If you sell an investment to realize a loss, you may miss out on potential gains if the investment recovers. Therefore, it's essential to consider the long-term implications of tax loss harvesting and weigh the potential benefits against the potential costs.
When Tax Loss Harvesting Makes Sense
Tax loss harvesting makes the most sense in certain market conditions and for investors in specific situations.
For example, tax loss harvesting can be particularly beneficial in a year where you have high capital gains. By realizing losses, you can offset those gains and reduce your tax liability. Tax loss harvesting can also be beneficial for investors in a high tax bracket as it can help reduce their taxable income.
Investors with large investment portfolios that have many individual holdings may also benefit from tax loss harvesting. With a larger portfolio, there are likely more opportunities to identify investments with losses, which can be used to offset gains and reduce taxes.
Tax Loss Harvesting vs Other Tax Strategies
Tax loss harvesting is just one tax strategy that investors can use to minimize their tax liability. Two other common strategies are tax-deferred accounts and tax-efficient funds.
Tax-deferred accounts, such as traditional IRAs and 401(k)s, allow investors to defer taxes on contributions and investment gains until retirement when they may be in a lower tax bracket. These accounts can be beneficial for investors who expect to be in a lower tax bracket in retirement.
Tax-efficient funds, on the other hand, are designed to minimize taxes by investing in securities with low turnover and tax-efficient structures. These funds aim to reduce capital gains and generate more tax-free income, such as from municipal bonds.
Each tax strategy has its advantages and disadvantages, and investors should consider their individual circumstances when deciding which strategy to use.
Conclusion
In conclusion, tax loss harvesting is a powerful tool that investors can use to reduce their tax liability and increase their after-tax returns. By identifying investments with losses, realizing those losses, and reinvesting in similar assets, investors can minimize their tax burden without significantly altering their investment strategy.
However, tax loss harvesting has its limitations, and investors should be aware of the IRS's rules and restrictions. It's also essential to consider the long-term implications of tax loss harvesting and weigh the potential benefits against the potential costs.
Finally, tax loss harvesting is just one tax strategy that investors can use. It's important to consider your individual circumstances and consult with a financial advisor before implementing any tax strategy. With proper planning and execution, tax loss harvesting can be an effective way to minimize taxes and increase after-tax returns.
If you are an investor with over $1 million in combined investments, excluding real estate, contact us for a free consultation to see how we can help you potentially improve after-tax returns on your portfolio.
Mark Fonville, CFP®
Mark is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors specializing in helping individuals aged 50 plus plan, invest, and enjoy retirement without the stress of money.
Forbes nominated Mark as a Best-In-State Wealth Advisor* and he has been featured in the New York Times, Barron's, Forbes, and Kiplinger Magazine.
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