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Explainer Video: Tax-Loss Harvesting

Mike Giefer, JD, MBA, CFP®

Director of Financial Education

Last Updated
December 20, 2021

A Tax-Smart Strategy for Periods of Market Volatility

Transcript:

Tax-loss harvesting can add value to your portfolio over time by strategically selling certain investments when they’re in a loss position. Financial markets are inherently volatile. Over long periods of time, we generally expect them to rise but, in the short-term, they tend to fluctuate and move sharply in either direction. Tax-loss harvesting is a strategy that seeks to take advantage of this volatility over time. In a perfect world, if investing was easy, we would simply put money into the market and then watch it grow over time at a nice, steady, smooth ascent – so that at some point in the future, we’ve earned a rate of return and we have more money than we originally put into the market.

Now, as anyone who’s invested before knows, the path to growth never follows a nice, smooth trajectory. Instead, there’s a lot more volatility in the process, and the path to growth over time often sees the markets go sideways, down, and have a lot of volatility in recovery. Ultimately, at the end of the day, if we’re patient and we stick with our strategy, we can grow our money. But, we have to withstand this type of volatility along the way.

How It Works

A tax-loss harvesting strategy seeks to take advantage of this volatility by identifying moments in the market cycle where your investment assets are down, and then selling out of those positions, booking an immediate tax loss, and then immediately purchasing very similar investments with the proceeds from those sales. So, you’re putting your target portfolio allocation essentially back together. Your portfolio composition is largely unchanged; and going forward, you can participate in that same growth and recovery. But in the process, we’ve booked a tax loss that we can use to offset income, both now and into the future.

Let’s take a look at a quick example. Say that you’ve purchased an investment, or a diversified portfolio of investments, for $100,000. After a few years, that $100,000 has grown 20% and is now worth $120,000. So, if you did nothing, if you just bought and held the investments over time and grew your money from $100,000 to $120,000, there really wouldn’t be any tax consequences as a result of holding everything. Maybe some interest and dividends get kicked off, but no capital gains or losses to report.

A tax-loss harvesting strategy is going to identify the moments in the market cycle where there is volatility and downturns in the market. So, let’s say hypothetically, there was a panic in the U.S. stock market. We see a sharp drop, and your $100,000 portfolio decreased 20% and is now worth $80,000. A tax-loss harvester is going to look at their investment holdings and identify the positions in their portfolio that contributed to this loss.

So, you sell those investments when they’re down. You’re able to recognize and book a $20,000 capital loss that we can use to offset income both now and in the future. Next, immediately, with the proceeds from those sales, purchase very similar, nearly identical investments that give you the same exposure to the asset class you just sold. You’ve effectively rebuilt your portfolio right back to where it should be.

Going forward, because your portfolio composition is largely intact and unchanged, you follow that same path of growth and recovery over time. Your $100,000 can still grow into that same $120,000, but in the process, by being proactive, we’ve booked a $20,000 capital loss that you can use to offset current year income. You can also carry the loss forward to offset future capital gains. At the end of the day, you aren’t changing your asset allocation or your overall investment strategy, you’re just being a little bit more mindful about how you can reduce taxes.

Wash Sale Rules and Other Important Considerations

It’s very important to note that tax-loss harvesting is only effective in taxable accounts where you’re paying as you go. Tax-loss harvesting does not work in retirement accounts – 401(k)s, IRAs or Roth IRAs – all of the activity in those accounts is sheltered for current year tax purposes. Secondly, and this is really important, you have to be very mindful of what’s known as the “wash sale” rule. The wash sale rule says that if you sell a particular investment at a loss, and then within 30 days of the date of that sale you purchase the exact same or an identical investment, the IRS is going to disallow the loss that you’re trying to realize from that first sale.

So, if you have stock in Company A and it’s down, you sell it at a loss, and then the next week purchase stock in Company A again, the IRS disallows that loss and you can’t use it to offset any of your income. Tax-loss harvesting works really well when you own a diversified portfolio and you’re using vehicles like exchange-traded funds (ETFs), mutual funds or other index funds, because there’s lots of different options out there that give you exposure to a particular asset class. And when they’re down, you can sell them and you can buy a very similar investment that gives you that same exposure, but this way you’re not getting tripped up by wash sale rules.

Lastly, when you’re doing tax-loss harvesting, you have to be very opportunistic about the process. So, a lot of times we get to the end of the year and people are looking for ways to reduce their current year income, and their CPAs are asking them to look at their portfolio and identify positions that might be selling at a loss so that it can reduce their tax liability. The volatility that creates the opportunity for smart tax-loss harvesting rarely occurs in the month of December. It happens randomly throughout the year. And so you (and your wealth manager) really have to be paying attention throughout the year and opportunistic when you’re trying to identify moments in the market cycle where tax-loss harvesting makes sense.

I’ve talked a lot in this space about the importance of tax planning around your investment portfolios and the value add over time. I talked previously about asset location, and tax-loss harvesting really just follows a similar mindset and strategy that if we can be mindful about the taxes in our portfolio, and be smart about trying to reduce some of that tax drag over time, we can add a lot of value to our portfolio and enhance our overall annualized rates of return without really changing anything with respect to our investment strategy.

Tax-loss harvesting is just another arrow in your quiver. If you’re paying attention to your taxable accounts during periods of market volatility, you can add a lot of value just by simply selling certain assets at a loss, buying similar investments, and then keeping your same investment strategy going forward over time.

An Experienced Advisor Can Help

At Creative Planning, we’re always looking for opportunities to make our clients’ portfolios more tax-smart as part of an overall strategy to legally and efficiently reduce income tax liability. As a nationally recognized wealth management firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, certified public accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your goals. We work together to help ensure all aspects of your financial life are well cared for.

If you’d like to learn more about tax-loss harvesting, asset location strategies, or any financial matter, please schedule a call.

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This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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