A common technique among intelligent investors aims to reduce the taxes they pay while also leave their positions intact; this is called tax-loss harvesting. You sell an investment losing value to compensate for capital gains on other investments and therefore lower the tax owed. This is especially useful for those who have a lot in taxable investments because you can accommodate tax consequences more effectively while maintaining the long-term discipline of your investment plan.
Tax-Loss Harvesting: The Mechanics
At its core, tax-loss-harvesting is straightforward: You sell depreciated investments to create what’s known as a capital loss. You can then use this loss to cancel out any capital gains you might have from selling other investments for a profit. Capital losses that are in excess of capital gains each year, costing them a $3,000 deduction against other income (like wages) every year. Any other losses are rolled over to future tax years.
For instance, if you invested $10.000 in a given tech company and its value went down to $7.000 due to market fluctuations… If you sell these shares, this means you made A LOSS of $3,000 on them. For example, if you also sold another investment that rose by $3,000 in the same year as your tech share loss,the gain from selling those other investments could be offset and there would not have to pay taxes on any profit.
The Wash-Sale Rule
The irs also features a wash-sale rule, which can be vital to help understand for tax-loss harvesting. If you buy an identical security within 30 days before or after the sale at a loss, that is called “washing” since it effectively cancels out and violates this rule which disallows the loss for tax purposes.
Benefits of Tax-Loss Harvesting
- Tax Deferral: By offsetting gains with losses, investors can defer paying taxes on capital gains, potentially allowing them to reinvest the money that would have gone to taxes.
- Portfolio Rebalancing: Tax-loss harvesting can be an opportunity to reassess your investment portfolio. If certain investments are underperforming, selling them can not only provide tax benefits but also allow you to reinvest in more promising opportunities.
- Reduction of Ordinary Income: If your losses exceed your gains, you can use the remaining losses to reduce your taxable ordinary income, up to a limit of $3,000 per year.
- Carrying Losses Forward: Unused losses can be carried forward to offset gains in future years, providing long-term tax benefits.
At What Point Should You Think about Tax-Loss Harvesting?
This only works for taxable accounts and is generally most helpful to people in higher tax brackets, because those are the folks who benefit from a deduction. More often than not, it is used toward the end of a tax year when investors look at their holdings and try to make any changes necessary to maximize the use of this tactic. But it can be done at any time in the year when market conditions provide a chance to book a loss.
You will also want to weigh this against the overall impact on your portfolio. However, selling an investment purely for tax purposes may not be a good move if it ends up changing your asset allocation or long-term goals. Having a financial advisor or tax professional can guide you on how to properly conduct your tax-loss harvesting decision while being true to your long-term strategy.
Potential Drawbacks
As good as all this may sound tax-loss harvesting does not come without cons:
Transaction Costs: A portfolio that is bought and sold quite a bit may incur transaction costs to the point where what you save in taxes might be offset by these fees.
Market Timing Risks: Selling an investment to capture a tax loss can expose you to market-timing risks. If the market turns around in that 30-day wash-sale period, you could miss out on gains.
Less Work: Because this decision is automatic, it takes work off of you to determine when and how much in taxes you oweComplexity: Tax-loss harvesting can add a layer of complexity for investors reporting the transaction results at tax time (especially if there were more than one per year or losses that will continue on into future years) The fact that it is complicated means you need to pay another professional for this task which leads also additional cost.
Taxes Receive Too Much Focus: Taxes are important, but not at the expense of investment discipline. Only focusing on tax-loss harvesting may not allow you to make the best investment decisions.
Conclusion
One of the most powerful ways Savvy investors use tax-loss harvesting to reduce their taxes and increase their after-tax returns.
