What Is Tax Loss Harvesting?
Part of what a good financial advisor does is help you respond to changes in our economic environment. Sometimes that includes managing your money when markets are behaving badly. No advisor has a crystal ball, and financial markets will go up and down. When they go down, what can you do about it?
You can sell, hold, or tax-loss harvest. For many investors, taking investment gains and harvesting tax losses can be an important tool for reducing taxes now and in the future. If used properly, this active tax strategy can save you money and help keep your portfolio diversified. It won’t restore your losses, but it’s a silver lining in a dark economic climate.
What is “tax loss harvesting”? Investment losses have tax benefits. Selling and staying out of the market locks in your losses, but it gives you a tax break. Continuing to hold a security that has lost value means you stay invested, but you have to wait for markets to make up for the decline in your holding. With tax loss harvesting, you sell an investment that has experienced a loss in value, but replace it with a similar one, realizing a tax benefit while maintaining your target asset allocation.
Benefits of tax loss harvesting are two-fold:
- You have a store of tax losses that can be used to off-set future gains, and
- You have up to $3,000 each year in tax losses to use against ordinary income
How does this work? Investments fall into asset classes: Short-Term Bonds, Large-Cap Stocks, International Developed Markets, and the like. Let’s say you invested $10,000 in XYZ S&P 500 Fund. As you likely know, the S&P 500 index tracks a list of 500 large US companies, so in our example, our investment in XYZ gives us a holding in Large-Cap Stocks.
You hold on to XYZ S&P 500 Fund for a couple of years, it goes up and down, and then we have a financial downturn. The value of your XYZ S&P 500 Fund holding falls to $6,000. While this may start the acid in your stomach churning, it’s helpful to take a deep breath and not panic. You are a long-term investor and know that markets have cycles, downturns are temporary, and the S&P 500 will recover (if it doesn’t, we have bigger problems). So you want to stay invested in the market, but who knows how long it will take to recover your losses.
If you sell your holding, you have a tax benefit in the form of the $4,000 investment loss ($6,000 current value of your investment – $10,000 purchase price, or cost basis). Let’s say you sell and take your tax loss. But then you’re out of the market. A better strategy might be to take your losses – but stay invested:
SELL XYZ S&P 500 Fund; take the $4,000 tax loss THEN
BUY ABC Large Cap Fund
ABC Large Cap Fund is also in the Large-Cap Stock asset class, just like XYZ S&P 500 Fund. You have “banked” the tax loss from your original investment, and stayed invested in the same asset class by investing in a similar fund. You won’t miss out on a recover in large cap stocks, and you don’t have to try to time the market to do it.
The Benefits When you file your tax return for the year, let’s say you have $500 in capital gains from other investments. You can use $500 of your tax losses to off-set the $500 gain (saving you $75 in federal taxes if you’re subject to the 15% capital gains tax rate). You can then use $3,000 from your “tax loss bank” to off-set ordinary income (wages, interest income, etc) on your tax return. At a 25% marginal tax rate, that saves you $750. You also have $500 in tax losses remaining from the original $4,000 that will carry-forward to the next tax year.
The Rules The IRS won’t let you simply sell an asset for a loss and immediately buy the same asset solely for the purpose of paying less tax. The loss will be disallowed if the same or substantially identical asset is purchased within 30 days. This is called the “wash-sale rule.” After the 30 days have passed, you can buy the asset you sold and still have the tax loss.
But you can immediately purchase a similar asset that is highly correlated with the one you’ve sold if you don’t want to wait the 30 days. Correlation means the two investments move up and down together in response to market changes. We wouldn’t expect stocks to change in value in the same way bonds would, given a certain economic hiccup; they are not highly correlated. But we would expect an S&P 500 fund and a Large Cap Stock fund to move closely in tandem.
Other Considerations To effectively use tax loss harvesting, you’ll need to consider transactions costs. How much is it going to cost you to buy and sell? If it costs you $10 each trade and your loss was $40 instead of $4,000, it doesn’t make sense to harvest your losses. Also, tax loss harvesting is only for taxable accounts – 401ks, 403bs, 457s, and IRAs are all tax-protected and as such have no tax loss/gain that you experience along the way. Additionally, transacting every time the market goes down can be costly from a tax-preparation standpoint. Lastly, with the latest round of “tax simplification” we now have four different capital gains tax rates, so a loss banked now may not always help you more later.
We can’t do anything about fluctuations in the market, but you can be smart about managing your own “harvest time” and taking tax losses carefully, while remaining invested in down markets. In this case, we saved $825 in tax, with a carry-over benefit to enjoy in future years. Research has shown regular tax loss harvesting to improve portfolio performance by 0.50% to over 1%. During the Financial Crisis in 2008-09, savvy advisors were “banking” losses for clients through tax loss harvesting, keeping their clients invested in the market so they enjoyed the tremendous growth we’ve experienced since then, while using a chunk of their tax losses each year to offset gains. Tax loss harvesting is one way you can take an active role in managing your portfolio with a strategy based on opportunity created by tax law, not market speculation.