What is Tax-loss Harvesting?

During market downturns – like the one this year - there is a silver lining strategy called “tax-loss harvesting” some investors can utilize. The strategy involves the timely sale of a security at a loss (keyword:  timely) in taxable accounts. In theory, the loss can then be used to reduce tax liabilities. 

The loss can offset two types of taxes:

• Capital gains.  If you have capital gains, you can first use losses to offset those gains.  The ideal result is you only pay taxes on your net profit, or the amount you’ve gained minus the amount you’ve lost. 

For example, if you sold stock in your individual account for a gain of $5,000, you would typically owe either long- or short-term capital gains taxes on this amount (at 20%, you would owe about $1,000 in taxes).  However, if you can harvest a loss of $5,000 from another holding, then your net gain is 0, thus decreasing or eliminating the taxable liability.

• Ordinary taxable income.  If you have no taxable gains, the IRS allows you to reduce your taxable income by up to $3,000. 
  
  Hypothetically, if you earn $150,000 in taxable income and use the 3k loss to reduce this to 147k, then you will pay taxes on 147k rather than 150k.  If you are in the 33% tax bracket, this will save you about 1k in taxes.

How can it benefit you?

Most investors assess the annual performance of their investment portfolios and other outside assets towards the end of the year and then make decisions about tax-loss harvesting.  For many investors, tax-loss harvesting can be a critical tool to reduce overall taxes.

What type of account do I need to have?

To utilize this with an investment portfolio of stocks and bonds, you need to have an account that is not a tax-advantaged retirement account (so you can’t utilize this strategy in accounts like IRAs, Roth IRAs, 401k, 403b, IRA, or SEP accounts).  You would need an account like an individual account or a joint account (or, a trust where your Social Security number is the same as the trusts).

Anything else I should know?

Two things:  there is something known as the “wash sale rule.”  The wash sale rule states an investor cannot sell one security and, within 30 days, either before or after the sale, purchase an identical or similar security.  Doing so will postpone the loss for IRS purposes until the new position is eventually sold.

Also, if you take more than a 3k loss in one year, you can carry forward the losses into future years.  For example, if you took a 10k loss, you could use 3k in net losses each year until the 10k runs out.

When should you NOT use this strategy?

Tax loss harvesting should NOT be used to time the markets as trying to time the markets is typically a losing bet.  For example, if you sell for a loss, we do not recommend waiting to get back in.  Either reinvest the funds into a different security immediately OR wait until the 30-day wash sale rule has passed and reinvest in the original holding.

The bottom line:  Typically, we believe it is a poor decision to sell an investment for a loss (our philosophy is grounded in buying well-researched investments at a fair price and holding them for the long term).  However, sometimes the market presents opportunities where tax-loss harvesting can be an extremely useful part of your overall financial planning and investment strategy.  Also, it is always our advice to check with your tax professional for your personal scenario – this article is meant to be general knowledge and advice.