This article was co-authored by Sierra Johnsrud.
Though many may wait until the end of the year to start discussions with their advisor around additional tax savings, one conversation you can have year-round to help your full financial picture is tax loss harvesting.
What is tax loss harvesting?
Tax loss harvesting is the process of selling a security in a taxable account for a capital loss to offset capital gains. Since tax-sheltered accounts — like an IRA or a 401(k) — are not taxed on the growth of the underlying investments, this strategy is typically applied in a taxable account. Selling an individual stock or mutual fund for less than you paid for it allows you to realize a capital loss to offset capital gains in the current year and/or offset capital gains in future years (thus the word “harvesting”). If there are no capital gains to offset, up to $3,000 of capital losses1 each year can be used as a reduction to ordinary income on your tax return.
In order to maintain an asset allocation that suits your long-term investment plan while taking advantage of tax loss harvesting, you can sell a security at a loss and use the proceeds to purchase a similar, but not substantially identical, security. Since the investor is buying an investment in the same area of the market, the investor’s overall portfolio allocation and exposure will not change in a meaningful way while realizing a capital loss. The below graphic highlights this example.
One important rule to keep in mind when implementing tax-loss harvesting is the wash-sale rule. The IRS created this rule to prevent investors from selling a security at a loss and repurchasing the same security immediately after just to claim tax benefits. Generally, this can be avoided by not selling and repurchasing a security issued by the same corporation or purchasing a substantially similar security such as the Vanguard S&P 500 ETF and the Schwab S&P 500 ETF.
Using market volatility
The deadline for tax loss harvesting in a given tax year is December 31, which is why most taxpayers wait to consider this strategy until the end of the year. However, to realize the strongest results, you should not look for last-minute bargains and instead look for tax loss harvesting opportunities as a year-round strategy.
US Market Intra-year Gains and Declines vs. Calendar Year Returns*
The above graphic shows the historical calendar-year stock market returns in blue bars, along with the intra-year gains and declines. Most years, the overall return for the market shown by the blue bars is positive; however, the red lines that show intra-year declines can present an opportunity to take advantage of the volatility in the market to tax loss harvest.
For example, if you invested in the market at the beginning of 2009, you could have sold your depreciated stock at -20% of what you paid for it to lock in a realized capital loss while simultaneously buying a substitute security to hold while the market proceeded to go back up. This strategy would have allowed you to lock in a capital loss to offset capital gains tax and improve your overall portfolio return.
The swings in the stock market happen throughout the entire year, as we’ve seen firsthand in 2020, making tax loss harvesting a valuable ongoing strategy to consider within your taxable accounts.
I don’t want to lose money — is this a risky strategy?
Some investors may delay selling a stock because of the psychological impact of turning a paper loss into a tangible financial loss. Other investors may hold the security hoping it bounces back from its decline. In both cases, maintaining a continuous tax loss harvesting strategy can turn the unrealized capital loss into a realized capital loss to save money on taxes. In addition, the investor stays invested in the market by buying a different security and ensures that their overall portfolio allocation remains the same. Rather than just taking the hit on your stock portfolio and waiting for the stock market to improve, you can use tax loss harvesting to add value where there otherwise would be none in a declining stock market.
So, why bother offsetting capital gains?
While it may be difficult for an investor to go against the classic “buy low, sell high” investment tactic, the investor is creating a “sell low, buy low” approach to enhance returns and reduce the impact of taxes that have a significate drag on portfolio returns.
When considering this strategy, it is important to remember that losses on your investments are first used to offset capital gains of the same type. Short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains. Net losses of either type can then be deducted against the other kind of gain. The significant difference is that short-term capital gains are taxed at your ordinary income rates, and long-term capital gains are taxed within three brackets of 0%, 15% and 20%, plus possible Net Investment Income Tax (NIIT) of 3.8% dependent on your income level.
Business owners with substantial capital gains after selling a business or investors with a large taxable account may use tax loss harvesting to minimize their tax liability while maintaining a diversified portfolio. No one likes seeing negative returns in their portfolio, like many did in the first half of 2020, which was a particularly volatile start to the year in the stock market. This is the reason for building diversified portfolios, paying attention to rebalancing and your asset allocation, and using a tax loss harvesting strategy year-round to take advantage of market volatility and decrease your tax liability.
*In US dollars. Data is calculated off rounded daily returns. US Market is the Russell 3000 Index. Largest Intra-Year Gain refers to the largest market increase from trough to peak during the year. Largest Intra-Year Decline refers to the largest market decrease from peak to trough during the year. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Values change frequently and past performance may not be repeated. There is always the risk that an investor may lose money. Even a long-term investment approach cannot guarantee a profit.