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The Power of Tax Loss Harvesting

 
 
 

Nobody likes seeing any of their investments drop in value. Likewise, not many are excited at the prospect of paying a lot of taxes, especially if avoidable. Losses in a portfolio can be used to offset gains (and even income) through tax loss harvesting. As they say, if life gives you lemons, make lemonade!

In a perfect world, all investments would go up and only up. The reality is, however, if you own a well-diversified portfolio, you are likely going to have some investments at a gain and some at a loss during any given period of time. It’s incredibly rare, for example, that US Equities, International Equities, Emerging Markets, US Bonds, International Bonds, etc. ALL go up in value during the same time frame. In fact, one of the values of diversifying your portfolio is to increase the likelihood that your investments are not correlated with each other (or that they do not act in the same way during market changes). Most understand that owning a well-diversified portfolio is in many peoples’ best interest to reach long-term financial goals, but how can you turn a negative (investment loss) into a positive (lower taxes)? The answer is through tax loss harvesting!

How Does Tax Loss Harvesting Work?

If all the tax mumbo jumbo hasn’t scared you off yet, hopefully the following example will help: Say you own one share of ABC Stock in a taxable investment account that was originally purchased for $100. If it trades for $150 per share today, and you decide to sell it, you are required to pay a capital gains tax on the $50 of growth ($150 sale price minus $100 purchase price equals $50 gain). If you held the stock for less than one year, you pay a short-term capital gains rate (based on your ordinary income), and if you’ve held the stock for over one year, you would pay the lower long-term capital gains rate. (The government provides a tax break for holding on to investments for over a year.) The $50 in growth in this hypothetical portfolio is the “capital gains exposure” meaning how much you would be taxed on if the gain is not offset by losses.

So, let’s take it a step further and harvest losses. Let’s say, in addition to owning ABC stock (with $50 in capital gains exposure), you also own one share of XYZ stock. You also bought this stock for $100, but it is currently trading for $50 per share after a rough year. You would not only have a capital gain of $50 (from selling ABC stock), but you would also have a capital loss of $50 if you sold XYZ stock ($50 sale price minus $100 purchase price equals $50 loss). Selling your share of XYZ stock would offset your tax liability, and free you from paying capital gains tax on the $50 gain from ABC stock. In short, you can sell one investment at a loss in order to offset the tax bill from selling an investment at a gain.

If you have a $500,000 portfolio with capital gains and losses outlined above, you could save some real dough on taxes. Assuming you fall in the middle 24% income tax rate, you could save up to $60,000 by offsetting short-term gains with losses. Though it’s an extreme example, the higher your tax bracket, the more beneficial this strategy becomes.

What Can you Offset Losses With?

The IRS requires that losses first be used to offset gains of the same kind. In other words, you must first offset short-term losses with short-term gains and long-term losses with long-term gains. For example, if you have $5,000 of short-term losses, you are first required to offset short-term gains. If you have less than $5,000 in short-term gains, you can use excess losses to offset long-term gains.

If you do not have any capital gains to offset losses against, the IRS allows you to deduct up to $3,000 of capital losses from your income each year. In other words, if your taxable income is $100,000, and you have investment losses (let’s say of $9,000 as an example) with no gains to offset it, you can deduct $3,000 so your taxable income is actually $97,000 for the year. The IRS also allows you to carry forward excess losses. So, in that example, you could deduct $3,000 for the next three years.

How to Get Started

Before embarking on any tax loss harvesting strategy, make sure you understand the basics of investing. If you work with a financial planner, make sure you ask him/her about any tax loss harvesting strategy currently being deployed. If you are investing on your own, you’ll want to review your unrealized gains and losses and realized gains and losses. Unrealized gain/losses relates to investments that have not been sold or “realized” yet. These are often called “paper gains/losses” because you are not actually taxed until you sell the investment(s). Realized gains and losses refer to actual gains or actual losses that you have incurred in your portfolio due to a sale of an investment or investments. These gains are subject to tax, so they’re a good starting point to understand how you can offset these.

You can begin matching up realized gains with realized losses. After you’ve matched up realized gains and losses, determine if you can offset any realized gains (in excess of realized losses) against unrealized losses. You can determine if it makes sense to sell an investment to realize a loss in order to offset a realized gain and reduce your capital gains exposure.

Keep in mind of the wash sale rule, which states that you must not buy back into anything you sell at a loss within 30 days. If you do, the IRS eliminate tax benefit on the loss. You can buy into a “substantially similar investment” as a workaround. So if you sell a large-cap equity ETF from one company at a loss, you can likely purchase a large-cap equity ETF from a different ETF company and avoid the wash sale rule. After 30 days, you can simply buy back into the first large cap equity ETF, assuming it better suits your long-term needs.

It’s advisable to consider your overall investment strategy (aligned with your risk tolerance and long-term goals) above any tax loss harvesting strategy. Of course, it might make sense to seek out a tax professional if you have complex questions on how this may affect your portfolio. The bottom line is having some of your investments at a loss in your investment portfolio is not the end of the world, and they can be useful in lowering your tax bill on investments at a gain.

Do you want to work with a fee-only financial planner to make sure you’re effectively tax loss harvesting in your own portfolio? Reach out to me at Ben@coveplanning.com or schedule a free consultation call.

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Ben Smith is a Whitefish Bay, WI fee-only financial advisor and CERTIFIED FINANCIAL PLANNER™ (CFP®) Professional serving clients in the greater-Milwaukee, WI area as well as virtually across the country. Cove Financial Planning provides comprehensive financial planning and investment management services to individuals and families, regardless of location, with a focus on Socially Responsible Investing (SRI). Ben acts as a fiduciary for his clients. He does not sell financial products or take commissions. Simply put, Cove Planning sits on your side of the table, and always works in your best interest. Learn more how Cove Planning can help you Do Well While Doing Good!

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Ben Smith, and all rights are reserved. Read the full Disclaimer.

 
Ben SmithTaxes, Investing