What Is Tax Loss Harvesting?
Tax loss harvesting is a strategic investment approach designed to help investors reduce their taxable income by offsetting capital gains with harvestable tax losses from other investments.
In other words, by selling securities that have decreased in value to realize a loss, you can counterbalance gains from other profitable investments, aiming to minimize your tax liability and possibly enhance your portfolio performance. However, it’s important to note that this strategy might lead to transaction costs and may not always align with your long-term investment goals. It also requires careful management to ensure it aligns with your overall investment plan.
How Does Tax Loss Harvesting Work?
Understanding the details of tax loss harvesting is important not just for potentially lowering your tax bill, but also because it can impact your overall investment strategy and financial planning. Here are some steps involved:
Generate a Capital Loss
Investors identify underperforming securities within their portfolio and sell them to realize losses. Good candidates may include investments that no longer align with your strategy, show limited growth potential, or serve a comparable role to other investments in your portfolio.
Offset Your Capital Gains
Next, subtract the total amount of realized losses from your capital gains. For tax purposes, the resulting figure is your net capital gain (if positive) or net capital loss (if negative). You will need to report this figure on Schedule D of your tax return.
Deduct Carryover Losses
If your harvestable tax losses exceed your gains, you can use up to $3,000 of the excess losses to offset ordinary income on your tax return. Any remaining losses can be carried forward indefinitely to offset income in future years.
Time Your Execution
Tax loss harvesting is commonly performed toward the end of the tax year when investors have the clearest picture of their portfolio’s overall performance throughout the year. However, you can perform tax loss harvesting any time significant losses are identified, potentially minimizing liabilities as market conditions fluctuate.
Follow the Wash Sale Rule
According to this IRS rule, an investor cannot repurchase the same or a “substantially identical security” within 30 days before or after the sale that generated the loss. The IRS enforces the wash sale rule to prevent abuse of tax loss harvesting. As violating this rule disqualifies the tax deduction, you’ll need to carefully plan your transactions.
Make Strategic Replacements
After selling a security to realize a loss, investors often purchase a similar, but not identical, security to maintain their portfolio's overall strategy and market exposure. This approach ensures the portfolio continues working towards the investor's financial goals without interruption.
Factors of Tax Loss Harvesting
Tax loss harvesting is one option for managing tax liabilities, especially for those with taxable investments. Here’s a balanced view of its potential benefits:
- Potential Tax Reduction: By selling investments that have decreased in value, you can offset gains from other investments, which may help lower your tax bill for the current year. This strategy could potentially save you on taxes, depending on your income and tax bracket. However, the actual tax savings can vary and may not always be as substantial as anticipated.
- Possible Enhancement of Future Investment Opportunities: Even greater rewards can stem from reinvesting the saved funds strategically. Consider reallocating proceeds to rebalance your portfolio, invest in promising opportunities, or strengthen positions in sectors and assets where exposure is currently lacking. Keep in mind, though, that these investments come with their own risks and may not always lead to increased gains.
Considerations for Tax Loss Harvesting
Working with a financial advisor will help you navigate the complexities of tax laws and investment strategies, including attending to:
Short Term vs. Long Term Capital Gains
Short-term gains are taxed as ordinary income, potentially up to 40.8% under current laws with the net investment income tax (not including any state income taxes), while long-term gains benefit from lower tax rates, ranging from 0% to 23.8% for high earners. This difference in tax rates can significantly impact the overall tax liability and the effectiveness of tax loss harvesting strategies.
Transaction Costs
Transaction costs associated with frequent buying and selling of securities can include brokerage commissions, bid-ask spreads, and potential impact on market prices due to large trades. When considering transactions, you’ll need to weigh these expenses against the potential benefits.
Market Timing
Tax loss harvesting should not drive investment decisions. It's important to maintain a long-term investment strategy and not make decisions solely for tax purposes. The focus should remain on achieving overall financial goals.
Professional Guidance
Implementing tax loss harvesting can be complex, particularly with considerations like the wash sale rule and strategic replacement. Working with a financial advisor can help you build a strategy that is executed in line with your overall financial goals.
Take Action
"It's not how much money you make, but how much money you keep," Robert Kiyosaki, author of Rich Dad, Poor Dad, once said.
Tax loss harvesting can be a tool for managing your tax liability and your investment portfolio.
To explore how this strategy might benefit your specific financial situation, contact an EP Wealth financial advisor today.
