How important is the impact of efficient tax management in your investment portfolio? Studies show that proper tax management can increase your portfolio’s return by 1% per year. Invested over 35 years, that can lead to a nearly 40% difference in the value of your portfolio.
This graph is based on investing $100,000 at the age of 30 and does not include the effects of inflation or other variables. It shows the final value of a 1% difference in annual returns. Final value at age 65: $1,070,000 at 7% and $770,000 at 6% – a nearly 40% difference.
While there are several ways you can effectively manage your taxes when it comes to your investments, disciplined portfolio maintenance can boost after-tax returns even further. One of the most powerful tax management techniques is tax-loss harvesting.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a technique you can use to proactively harvest available losses to offset gains by selling depreciated securities. The cumulative tax savings can make a real difference in your life, whether that means retiring earlier, helping your kids pay for college, or leaving behind a larger legacy.
This simply means selling positions that have declined in value since you originally bought them, thereby realizing a “loss” (as defined by the IRS). These losses can be used to offset other gains you have realized during the year. This can help lower your overall tax bill since your tax is paid on the net amount.
It’s slightly counterintuitive—after all, you’re supposed to sell high, right? But the idea is not to eliminate exposure entirely; it’s only a temporary sale to reduce your tax bill, after which, if you want to, you can buy back the same stock following a 30-day waiting period. And even if you don’t have any gains to offset, the IRS allows you to deduct up to $3,000 in capital losses from your ordinary income each year (any loss in excess of $3,000 can be carried over and deducted in subsequent tax years).
It’s worth nothing that anyone can deduct $3,000 in losses—it’s completely independent on whether you do tax-loss harvesting. In addition, although you can deduct only $3,000 in a given year, you can carry the losses over to subsequent years until they’re exhausted. So, for example, if you lose $15,000 in one year, you have five years of IRS deductions that can offset gains or add to the loss carryover.
How Does Tax-Loss Harvesting Work?
A portfolio of stocks is likely to have both winners and losers in any given year. If left untouched, this can lead to material portfolio deviations where the changes in value in individual securities cause the portfolio to become imbalanced.
Tax-loss harvesting creates an opportunity to rebalance the portfolio back to model weight—you can claim losses and simultaneously pare down winners with large embedded gains. Capital losses are first used to offset capital gains, and if capital losses exceed capital gains, you can offset up to $3,000 of other taxable income per year. The end result is a helpful tax benefit: a potentially higher net after-tax return and a well-balanced portfolio.
In the example below, a hypothetical investor owns 10 securities in his portfolio. Three of them have currently lost value: Stock A, which is down 10%; stock B, which is down 7%; and stock C, which is down 4%. The remaining stocks are currently higher than when he bought them.
Utilizing tax loss harvesting, the investor could sell stocks A, B and C in order to realize those losses, which he could then use to offset the gains from the stock winners. He could then purchase shares in a diversified ETF in order to stay invested for at least 30 days and avoid the wash sale rule (see below). After the 30 days are up, he can repurchase the same securities he sold if he believes they will rebound in value.
*Source: Personal Capital, Our Investment Methodology
Keep in mind that tax-loss harvesting tends to work best when you own individual securities, like stocks and bonds. Mutual funds don’t give you the opportunity to strategically sell positions. The known benefits of risk reduction and tax avoidance often justify the unknown benefit of hoping for a rebound in the stock that is down. Traditionally, investors consider selling assets in taxable (i.e., non-retirement) accounts that have losses at the end of the year.
Lowering Capital Gains Taxes
Effective tax-loss harvesting decreases your capital gains tax. The capital gains tax is levied on the profit you receive from the sale of an investment. It’s typically owed once a sale is “realized,” i.e., when the asset is sold or exchanged at a price different from the original cost. You are only taxed on your return on investment if your net gains for that year are positive.
Capital gains tax is based on how long you have owned the asset. If you’ve held the asset for one year or less, the profit is considered a short-term capital gain; if held for more than one year, the profit is taxed as a long-term capital gain. Short-term capital gains are taxed as regular income, which for most taxpayers is a higher tax rate than the long-term capital gains rate.
Additional Factors to Consider for Tax Loss Harvesting
One important factor to consider with tax-loss harvesting is the so-called wash sale rule. This rule states that you cannot purchase the same security within 30 days before or after the sale and claim the loss; if you do so, your loss would most likely be deferred until the security is completely sold.
The rule goes a bit further to say that you also can’t buy a new security that is “substantially identical.” For instance, if you sold an S&P 500 Index ETF to claim a loss, you can’t turn around and buy a new S&P 500 Index ETF from a different provider inside of 30 days. But if you sold a handful of stocks, you could buy a broad-market equity ETF in their place. You would then hold it for 30 days to maintain stock exposure and avoid the wash sale rule.
The wash sale rule gets really complicated when a loss occurs when you purchase additional shares, purchase new shares, sell only a portion of the original or new shares, and hold on to shares. Additionally, the wash sale rule applies to the aggregate of your accounts, including your IRAs, so you will want to be very careful if you have the same stock in different brokerage accounts. A CPA can help you in these situations to make sure the wash sale rule is applied correctly.
If you don’t want to wait 31 days to buy the same stock or security, you may consider replacing the investment you sold at a loss with an ETF tied to the company’s industry or sector. In this way, the ETF effectively serves as a temporary approximate proxy for individual stock holdings and still enables you to recognize the loss on your original position.
The cost basis calculation is another important factor to consider with tax-loss harvesting. You’ll need to know the cost basis of the securities you sell, or what you originally paid for them, in order to calculate your capital losses and gains. To make this calculation, determine the date when you first bought the securities and the price you paid.
This might be challenging if you bought securities over time using dollar-cost averaging. You can contact the brokerage firm you bought securities from, which should be able to provide this information to you.
Some investment managers provide complimentary harvesting of tax losses, which automates the process and makes it easier for you.
Should You Use Tax-Loss Harvesting?
Tax-loss harvesting is only used with securities held in taxable investment accounts, not retirement accounts. In fact, research has determined that using the strategy resulted in an additional annual return of nearly 1% each year between 1928 and 2018.
The best time to implement the strategy is usually when markets are down because this may offer the greatest opportunity to buy replacement securities at low prices.
Tax-loss harvesting tends to be most beneficial for individuals in high tax brackets since they can potentially realize the greatest tax savings. Single individuals with less than $40,000 in annual income, or married couples filing jointly who make less than $80,000 per year, don’t owe any capital gains tax so the strategy won’t help them.
Read More: How to Avoid Capital Gains Tax
The Bottom Line
Tax optimization is one part of your overall financial plan. You can take a few actions now to get yourself on the right track.
Download 5 Tax Hacks for Investors, an actionable guide to tax optimization with insights from fiduciary financial advisors. The guide is free.
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Consider talking to a fiduciary financial advisor for more detailed guidance on your tax optimization strategies.