What is Tax-Loss Harvesting?
Tax-loss harvesting is the process of selling a security at a capital loss and taking the proceeds to purchase a similar investment. This loss is then used to offset any capital gains that were realized across one’s taxable accounts or gains from the disposition of other property, and the account remains invested relatively the same. Note this strategy does not apply to any tax-advantaged account such as an IRA, Roth IRA, or 401(k). If an account does not have any capital gains or the losses exceed the annual gains in the account, any losses can then be applied to one’s ordinary income, like wages or taxable IRA distributions, up to $3,000 in a calendar year. Any further losses beyond $3,000 can be carried forward and applied to future capital gains and ordinary income indefinitely. Here’s an example of how tax-loss harvesting can help when taxes come due:
In this example, we’ll look at two different hypothetical investors with the same income and investment portfolio. The first investor decides to harvest $15,000 in losses in their account and use the proceeds of the sale to purchase a similar investment. The second investor takes no action.
The first investor was able to offset their ordinary income by $3,000, lowering their tax due by $911 against the investor who took no action. Let’s take this example a step further and jump ahead one year. We assume both investors realize $12,000 in gains.
The first investor carried forward $12,000 of capital losses to the next year and rebalanced their account without generating a tax liability. The second investor generated a tax liability of $1,800 when rebalancing their account. Over a two-year period, the first investor saved $2,771 in taxes. While this is a very simple example, it’s clear that tax-loss harvesting can have a dramatic impact on one’s tax liability. This impact results in tax alpha, or the extra tax savings of a tax-efficient portfolio. While benefits are not evident in account performance, tax alpha can create significant benefits for one’s tax and financial situation. The real magic of tax-loss harvesting happens when those savings pile up over time and remain invested in the portfolio. Money paid in tax today does not have the chance to compound and grow over time.
What’s the Catch?
While tax-loss harvesting may be one of the most advantageous sections of the tax code for investors, it comes with a key caveat: the wash sale rule. A wash sale, by the IRS’s standards, occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you violate one or more of the following conditions:
1. Buy substantially identical stock or securities
2. Acquire substantially identical stock or securities in a fully taxable trade
3. Acquire a contract or option to buy substantially identical stock or securities
4. Acquire substantially identical stock for your individual retirement account (IRA) or Roth IRA
These rules apply to households, spouses, and controlled corporations as well, meaning your spouse could not purchase a substantially identical security you sold at a loss within 30 days without triggering a wash sale. Triggering a wash sale results in a disallowed loss. Essentially, you will not be able to deduct your losses for tax purposes, and the value of the disallowed loss will then be applied to the cost basis of the new security.
While the wash sale rule limits tax-loss harvesting to an extent, the current investing landscape offers investors easier ways to tax-loss harvest without compromising targets and factor exposures in their investment portfolio. Low-cost index funds are plentiful, and many are highly correlated without being substantially identical. This allows investors to harvest their losses without missing any recovery.
What It All Means
The financial markets can be wildly unpredictable in the near term, and it’s likely that investors will face losses in their taxable accounts at some point. Tax-loss harvesting is often described as making lemonade from lemons. No one likes bear markets, but tax-loss harvesting is a tax-efficient investment strategy that can accrue tax savings over time.
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