The idea of tax-loss harvesting may sound counterintuitive — after all, the process involves selling investments that are down to lock in a loss (and isn’t the standard investment mantra “buy low, sell high”?). Yet, as crazy as it may sound to intentionally realize investment losses, tax-loss harvesting is an important tax planning strategy that very few investors use but shouldn’t be overlooked.
What is tax-loss harvesting?
Within a taxable investment portfolio (also known as a non-retirement account), you’re only taxed on net capital gains, which equals gains minus losses. This means any realized losses in a given year can be subtracted from capital gains in order to reduce your tax liability.
Tax-loss harvesting is the strategy of selling an investment that has declined in value in the short term, and replacing the investment with a highly correlated alternative. If done correctly, the result is that the risk profile and expected return of your portfolio remain unchanged, but up to $3,000 per year in investment losses can be used to offset ordinary income. If you realize more than $3,000 of losses in a single year, you can carry over the excess amount to offset capital gains in future years.
By realizing an investment loss within your portfolio, you can access a tax deduction then reinvest your tax savings to stay invested in the market.
It’s important to note that tax-loss harvesting only works within taxable investment accounts. This strategy cannot be employed in tax-deferred accounts, such as IRAs and 401ks, because their tax-deferred status means they aren’t subject to capital gains taxes.
Beware of the wash-sale rule
When implementing a tax-loss harvesting strategy, be aware of the IRS’s “wash-sale” rule. This rule is intended to prevent investors from selling at a loss for the sole purpose of obtaining a tax deduction as they continue to maintain their current investment allocation.
The wash-sale rule is triggered when an investor sells an investment at a loss and, within 30 days before or after the sale, buys back a “substantially identical” security. A wash sale is also triggered when an investor’s spouse or a company controlled by the investor buys a substantially identical security during the 30 days before or after selling a security at a loss.
If your security transaction triggers the wash-sale rule, the tax loss will be disallowed. The rule also applies when you sell an investment at a loss in a taxable account then buy it back in a tax-advantaged account.
Tax-loss harvesting examples
As an example, let’s consider Joan Investor, whose income places her in the 37% income tax bracket and whose capital gains tax rate is 20%. Joan has the following unrealized gains and losses within her investment portfolio:
- Stock A – Held for 652 days, unrealized gain of $250,000
- Stock B – Held for 556 days, unrealized loss of $150,000
- Stock C – Held for 95 days, unrealized loss of $80,000
Joan completes the following trades throughout the year:
- Stock D – Sold for a realized gain of $200,000 after holding for 425 days (long-term capital gains)
- Stock E – Sold for a realized gain of $120,000 after holding for 125 days (short-term capital gains, taxable as ordinary income)
Without tax-loss harvesting, Joan would owe the following taxes on her trades:
($200,000 x 20%) + ($120,000 x 37%) = $40,000 + $44,400 = $84,400
If Joan decides to realize losses by selling Stocks B and C, she could use those losses to offset a portion of her gains as follows:
(($200,000 – $150,000) x 20%) + (($120,000 – $80,000) x 37%) = $10,000 + $14,800 = $24,800
As you can see, Joan could avoid $59,600 in tax liabilities this year by taking advantage of tax-loss harvesting within her portfolio.
However, if Joan makes the mistake of purchasing a substantially identical security to Stock B or Stock C within 30 days before or after the sale, she would trigger the wash-sale rule and wouldn’t be eligible to offset her capital gains with her realized losses.
The bottom line? Tax-loss harvesting is an important tax planning strategy, but it must be executed correctly in order to avoid the wash-sale rule.
Could you use some help successfully implementing tax-loss harvesting within your portfolio? Creative Planning is here for you. Our teams have experience navigating a wide range of tax and financial challenges with one objective in mind: helping our clients achieve their long-term goals. For help with your tax planning strategy or any other financial matter, please schedule a call.