Maximizing your investment returns involves more than just selecting the right asset allocation or investments. It also entails implementing effective strategies to manage and potentially reduce your tax liabilities. And, whether investors know it or not, they have powerful tools at their disposal that can help them potentially enhance their bottom line by utilizing tax-wise strategies, and tax-loss harvesting is one such tool.
In this post, I’ll discuss how tax-loss harvesting works, its benefits, and pitfalls to avoid.
What is Tax-Loss Harvesting?
First, tax-loss harvesting only applies to taxable accounts or assets held outside of tax-deferred or tax-free accounts. For assets held inside tax-advantaged accounts, such as 401(k)’s or IRA’s, the strategies below will not apply.
When you sell an investment for more than its purchase price, the profit is considered a capital gain, which is taxable income. On the other hand, when you sell an investment for less than its purchase price, the result is a capital loss. Losses actually have value because they can be used to offset (reduce) capital gains or ordinary income, thereby reducing the amount of tax you owe.
When tax-loss harvesting, you intentionally sell investments that have declined in value to realize a capital loss; the goal being that you use the losses to lower your taxable income.
Capital losses can be used to lower or eliminate capital gains, and if your capital losses exceed your capital gains in a given year, under current tax law, you can use the excess loss to reduce other income up to $3,000 a year. Any unused losses can be carried forward indefinitely and used in future years.
Example 1: You currently have $20,000 in realized capital gains from trades you made this year, meaning you will owe capital gain tax on this amount. Looking through your portfolio you find a mutual fund that, if sold, would generate a $15,000 loss. You sell the fund, realize the loss, and bring your realized gains for the year down to $5,000. Harvesting this loss has now reduced your income subject to capital gains tax by $15,000.
Example 2: You have an annual salary of $150,000 and want to reduce your taxable income. A fund in your portfolio has depreciated $10,000 from its purchase price and you decide to sell the fund and realize the loss. Assuming you have no capital gains this year, you can reduce your taxable income by $3,000. The remaining $7,000 loss is carried forward and either applied toward future capital gains, used to reduce taxable income up to $3,000 per year, or both, until the loss is fully utilized.
Beware the Wash-Sale Rule
Once you have sold a security and generated a loss, the question now is what to do with the proceeds. When harvesting a loss, you must remain true to your investment plan and reinvest the proceeds in a manner that’s consistent with your existing portfolio allocation. After all, we aren’t selling in an attempt to time the market, we’re selling to reduce taxable income and enhance after-tax returns, so we want to make sure we don’t alter our portfolio. However, reinvesting the proceeds requires special attention as you might trigger the IRS wash-sale rule.
The IRS wash-sale rule is a regulation that prevents investors from fabricating losses to receive tax benefits and can apply to stocks, bonds, mutual funds, ETFs, and options. If an investor sells a security at a loss and purchases the same security, or a substantially identical security, 30 days before or after the sale, the loss is disallowed.
Triggering the wash-sale rule can result in a higher tax bill as the loss cannot be used to offset gains or reduce taxable income. However, the loss isn’t gone forever. The value of the loss will be added to the cost basis of the newly acquired shares and used when the investment is ultimately sold, but you lose the immediate tax benefit.
Here's an example:
You purchased $100,000 of the Vanguard S&P 500 Index fund and sold the fund for $90,000, providing you with a $10,000 loss that can be used to offset capital gains and/or reduce ordinary income. Over the following two weeks the S&P 500 Index declines in value. Unable to resist the lower price, you repurchase $100,000 of the Vanguard S&P 500 Index fund. You have now triggered the wash-sale rule because you bought the identical investment within 30 days of selling the original investment.
The original $10,000 loss is now disallowed and will be added to the cost basis of your newly purchased shares. The cost basis for your newly purchased shares will be $110,000 ($100,000 cost basis + $10,000 loss disallowed = $110,000).
Two Ways to Avoid the Wash-Sale Rule
Option 1: Using the example above, after you have sold your Vanguard S&P 500 Index fund, you wait 31 days from the date of sale and repurchase the same fund. You haven’t triggered the wash-sale rule, but the money will sit on the sidelines for 30 days. This method involves some speculation as the price could be significantly different after 30 days, potentially negating any tax benefit received from harvesting the loss.
Option 2: Again, using the example from above, instead of buying the Vanguard S&P 500 Index fund, you buy a similar fund, but not one that is substantially identical. The IRS is somewhat vague on what they consider “substantially identical,” so it is best to err on the side of caution. In this example, you could purchase another market cap-weighted US index fund that closely tracks the S&P 500, but with a slight variation (perhaps targeting the largest 100 US stocks or the largest 1000 US stocks) and not trigger the wash-sale rule. After 30 days have lapsed, you can decide if you want to move back to the original investment or stay put.
Don't Try to Outsmart the IRS
Before you try to outsmart the IRS and find ways around the wash-sale rule, don’t, because they have already considered this possibility. If you do any of the following 30 days before or after harvesting a loss, you will trigger the wash sale rule:
1. Purchase the same security in a different taxable account.
2. Purchase the same security in a tax-deferred account such as an IRA.
3. Purchase the same security in your spouse’s accounts.
4. Purchase an option contract that tracks the liquidated security.
The bottom line: it is better to wait the 30 days or find a suitable replacement that is similar but not identical.
As you can see, tax loss harvesting can be complicated, and can backfire if done improperly. When in doubt, consult with an investment or tax professional.
The Benefits of Tax-Loss Harvesting
The obvious benefit of tax-loss harvesting is a reduction in taxable income and a lower tax bill, and, the higher your marginal tax rate, the more bang for your buck you receive. However, there are other benefits and strategies to consider, including:
Over time the value of your investments can drift from their target allocations. Rebalancing your portfolio brings those investments back to their targets, and the buying and selling of investments can produce capital gains or losses. By incorporating tax-loss harvesting into your rebalancing plan, you can not only bring your portfolio allocations back into balance, but you can potentially lower your tax bill at the same time.
During periods of market volatility, tax-loss harvesting can turn market downturns into tax advantages. By realizing losses during a down market, you can bank those losses for future use as they can be carried forward indefinitely and never expire. When the market ultimately recovers, you have tax-saving losses that can be used to offset future gains, giving you more flexibility when it comes time to sell shares at a gain.
Managing a Concentrated Stock Position
A concentrated stock position is a situation where a significant portion of an investor’s portfolio is invested in a single stock. This can be especially common for employees of public companies who accumulate significant shares of their company’s stock. Concentrated positions can expose the investor to diversification risk as well as create significant taxable gains when they ultimately start liquidating shares. By proactively harvesting losses in an investment portfolio, an investor can accumulate losses to offset gains when they eventually start unraveling their large, concentrated position.
The goal of managing your portfolio in a tax-efficient way is to maximize your after-tax returns, because, after all, your after-tax return is what you actually get to spend when all is said and done. When you reinvest the tax savings from a tax-loss harvesting strategy, they can compound your returns over time, potentially leading to increased wealth.
Sale of a Business or Real Estate
Capital gains and losses from one asset class can be applied to another asset class. Gains from the sale of a business or real estate can be offset by losses from your investment portfolio, or visa versa (for a real estate professional a different set of rules may apply, so make sure you consult with a tax professional).
When an individual dies owning appreciated assets, their heirs receive a step-up in basis where the new basis is the value as of the date of death. For instance, you inherit shares of Microsoft from your grandfather. He purchased the shares for $50,000 and the shares were valued at $75,000 on the date of his death. Your cost basis is now $75,000. However, if someone owns depreciated property as of the date of their death, their heirs receive a step-down in basis and the loss can’t be used. If an investor’s health takes a turn for the worse, and there are losses in the portfolio, harvesting losses and putting them to use while the individual is still alive might be a worthwhile consideration. Those losses can be used until the individual passes, and utilized on their final tax return in the year they die.
Tread Lightly and Seek Advice
Tax-loss harvesting is a worthy strategy that can help you manage your investments, reduce taxes, and potentially enhance your overall investment returns. However, tax-loss harvesting must be applied skillfully, and it's essential to consider your individual circumstances and tax situation. As always, it's recommended to consult with a tax professional or financial advisor before implementing a tax-loss harvesting strategy.
Tad Jakes, CFP®, EA