What Is Tax Loss Harvesting?
Maximizing the after-tax return rate of your portfolio is an important, long-term objective which involves reducing the impact of taxes on the portfolio when possible. Tax loss harvesting helps you meet this objective by either reducing or eliminating the taxes on capital gains in a given year. Basically, the loss harvesting strategy involves intentionally capturing capital losses and using them to offset, or balance out, your gains.
The IRS doesn’t know whether you have a capital gain or a loss on a security until after it’s sold. A capital gain or loss occurs when you sell a security (stock, mutual fund, ETF) for more or less than its “basis.” A security’s basis is the purchase price after commissions or other expenses and is also known as the “cost” or “tax” basis.
Ideally, you harvest a loss, when the value of a security is below its basis. You then purchase a “replacement” security which is similar and hold it for at least 31 days. After that, you can sell the replacement and buy back the original. However, care must be taken not to choose a replacement security which is substantially identical – a twin. You wouldn’t want to pick the T Rowe Price Index 500 as a replacement for your Vanguard Index 500 as they have essentially the same holdings and benchmark index. This would negate any offsetting tax benefit through a violation of the IRS “Wash Sale” rule (more on this rule later in the article).
Tax loss harvesting may be appropriate for you if you think that you might have:
- A heavy capital gains burden this year,
- Expect to stay at a similar tax rate, or
- Your tax rate may go down in the future.
While this concept may not be difficult to grasp, special care must be given to ensure that the correct procedures are followed to prevent costly mistakes. These transactions are irrevocable and need to be precise.
Furthermore, this strategy is not appropriate for retirement accounts such as your 401K, IRA, or Roth. Those accounts are already tax-advantaged by their nature.
A Helpful Resource
I have a checklist, “What Issues Should I Consider When Harvesting Capital Losses?” that can help you better prepare and determine whether harvesting capital losses is appropriate for your financial situation.
This checklist covers some key issues to consider when you are thinking of implementing a tax-loss harvesting strategy. Issues such as:
- The effect harvesting losses may have on your overall portfolio goals.
- Some common pitfalls and rules to be aware of when harvesting losses.
- The potential tax benefits and consequences that may arise.
- How long-term goals may be affected by tax-loss harvesting.
More On Tax Loss Harvesting
If your capital losses are larger than your capital gains, the difference can be used to offset up to $3,000 of your ordinary taxable income. Any remaining losses can be carried forward to future tax years. As an example, if this year your losses total $7,000 and your gains total $3,000,
- The losses fully offset the gains,
- $3,000 of losses can be used to offset $3,000 of ordinary, taxable income, and
- The remaining $1,000 of losses may be carried forward to offset gains or income in the future.
Pay Attention to Costs
As you regularly monitor your portfolio for tax-loss harvesting opportunities, one important consideration is the dollar amount of the tax benefit relative to any transaction costs. These are the costs which are associated with the sale of the security and paid to a Broker and/or Advisor. You may need to set boundaries to ensure that the tax loss harvest is profitable. Setting a minimum dollar loss and/or a minimum percentage loss may help. As an example, you may only seek to harvest the loss in a security if it drops below a threshold of $5,000 or 5%. Please note: those minimums are arbitrary and will not necessarily be beneficial in your situation.
Avoid Wash Sales
As a long-term investor, your goal should be to remain invested on a consistent basis, because market fluctuations can quickly turn losses into gains. Therefore, when you sell a security to harvest a loss, you should quickly purchase a replacement security that is similar but not “substantially identical”. Purchasing a substantially identical security within 30 days before or after the sale of the original security violates the IRS “wash sale rule.” After 31 days you can safely sell the replacement and repurchase the original security. However, if there is a sizeable gain in the replacement security during the 31-day period, it may not make sense to swap back to the original.
It is important to note that there are no clear guidelines on what constitutes a substantially identical security, and the IRS makes the final decision whether or not the wash sale rule has been broken.
To fully capitalize on the strategy, one must evaluate their portfolio for loss harvesting opportunities throughout the year. Many will use this strategy only for year-end tax planning. This approach may be ineffective – even counterproductive – since losses can occur at any point during the year. If the security’s value were to rebound quickly, the opportunity to harvest the loss would close.
Other Tax Issues To Consider
Short vs Long-term Losses
Pay attention to the classification of the capital loss, whether it is “long-term” or “short term.” A short-term loss is realized when you sell a security that has been held for less than one year. Short-term losses can only be used to offset short-term gains which are taxed as regular income. You cannot use these short-term losses to offset gains from securities held for longer than one year (long-term gains).
A wise investor can also reduce current and future taxes by concentrating tax-efficient securities into regular non-retirement accounts. These are securities which are taxed at lower rates, generate little to no taxable income, or the income earned is tax-free at either the federal or state level. Some examples of these securities are:
- Individual stocks held for more than a year
- Tax-managed stock funds, index funds, exchange traded funds (ETFs), and low-turnover stock funds
- Qualified dividend-paying stocks and mutual funds
- Series I bonds, municipal bond funds
Tax loss harvesting results in real, tangible tax savings. In addition, this strategy may create other planning opportunities and economic benefits. Deductible capital losses come in very handy when faced with future portfolio rebalancing or restructuring when you are adapting to changing goals or life events. What’s more, lowering your taxable income now may open the door further to other planning strategies, allowing you to manage your lifetime tax bill more effectively.
Wherever you are on your financial journey, your goal should always be to make investment decisions based on financial objectives, not market whims. So, if harvesting capital losses is missing from your financial plan, there is no better time to start than now. I would love to discuss my checklist, “What Issues Should I Consider When Harvesting Capital Losses?” with you sometime soon.