The goal of tax-loss harvesting to lower your overall taxes. With proactive tax planning, you may be able to lower your taxable income by selling off losing investments. Similarly, you can offset some long term gains by selling investments that may have lost money over the long term. In this article, we will share with you what you need to know about tax-loss harvesting.
Buys Low Sell High?
The first lesson of investing is to buy low and sell high. This may be easier said than done in real life. Even within a portfolio that had done amazingly well, a few investments may have lost money. Or perhaps, just a few shares of an investment has lost money in the short term.
In the not so distant past Tax-loss harvesting was mostly reserved for the uber-wealthy. With new technology and the lowering of trading commissions, anyone with investment accounts can benefit from knowing about tax-loss harvesting. Saving money on taxes is saving money on taxes. Granted, the bigger your accounts or, the higher your income, the bigger the tax savings may be.
What is the Point of Tax-Loss Harvesting?
In plan English, tax-loss harvesting amounts to selling investments to minimize the taxes on your investment portfolio. In the simplest terms, this is more about taxes than investing.
When using tax-loss harvesting in real life, it is a bit more complicated than the description above. You can harvest short term losses as well as long term losses. Depending on your situation, one may be way more valuable than the other.
When we are tax-loss harvesting, we are selling certain shares of an investment at a loss to reduce taxes on the investment portfolio at the end of the year. You can use up to $3000 of short-term losses to offset regular income. If you are selling an investment with a long term capital loss, these losses can help offset the capital gains from other investments that have been sold for a profit.
Can I use tax-loss harvesting on my retirement accounts?
Buying and selling of investments within your retirement accounts are not taxable events. With that in mind, there is no need and no benefit from tax-loss-harvesting within a retirement account.
You will want to apply tax-loss harvesting only to your taxable investment accounts.
Example of Tax-Loss Harvesting
Let’s say that you have $100,000 in realized capital gains on certain index funds within your investment account. We have been in a bull market for over a decade, some of you are likely sitting on some huge capital gains. To minimize the tax liability from those gains, you sell other assets that will help generate a loss. If those losses total $50,000, they will cut your net capital gains taxes in half. With half the realized capital gains, you will have half the tax liability for these gains. We will dig a little deeper into how this actually works, a little later in this post.
Is Tax-loss Harvesting Really that simple?
Sadly, tax-loss harvesting is not all that simple in practice. When trying to do this manually- tax-loss harvesting can actually be quite complicated and labor-intensive. Back in the day, we had to do this tax planning process with excel spreadsheets. Blah. Now the process of tax planning is much easier, as much of the heavy lifting can be done with computers and software.
If your financial advisor is not idiot, they should have your accounts set up to run as tax-efficiently as possible. It is a little extra work for the advisor, but the tax savings for you can be huge.
Wash Sales and Tax-Loss Harvesting
As I mentioned before, tax-loss harvesting is all about saving on taxes, not so much about investing. So, on some occasions, you may want to just temporarily sell some portion of an investment holding to take a tax loss now, and then you can rebuy it in the future. If tax-loss harvesting is not done properly, it will create a wash-sale that will eliminate the tax benefits of the buying and selling.
This wash sale rule was a way for the IRS to prevent taxpayers from creating tax losses using investment in the extreme short term. The wash sale rule requires that a loss on a sale will not be given if the same or substantially identical security is purchased again within thirty days or the original sale that resulted in the loss.
That means either / both thirty days before the sale or thirty after. For example, you can buy 1000 shares of XYZ fund on January first. Followed by a sale of 1000 shares of XYZ fund that you already owned, which had a loss on January 2nd. This will result in a wash sale, and any losses will be disallowed.
Avoiding wash sales, and finding the best shares to sell can get quite cumbersome when you have multiple holdings in your portfolio. With the help of software, a fiduciary financial planner like myself can do tax-loss harvesting for all of my clients. In the past, a firm may have had to have a full-time employee just to handle this type of thing.
The best way to get around the wash sales rule is to make sure that you wait at least thirty-one days after the sale of an investment before you buy it back. (Assuming you buy it back at all). Another is to purchase a similar, but not identical, investment to the one that sold. This could involve say, selling bank stocks, and buying shares in a banking fund immediately after. Or perhaps, you move from one index fund to a slightly different index fund.
Tax Harvesting Short Term Losses and Long Term Losses
You can tax harvest both short-term losses as well as long term losses. Short term losses are on an investment held less than a year. Long term losses are for investments held longer than a year. Long-term capital gains are typically taxed at a much lower rate than short-term gains. Short-term gains are typically taxed like regular income. With that in mind, harvesting short-term losses are more valuable in general, than long-term losses when tax-loss harvesting.
Hopefully, by now, you have gathered that the primary reason to partake in tax harvesting is to defer taxes. That is, you are pushing the payment of as much tax as possible are far into the future as possible. Paying fewer taxes now will help allow your investments to compound and grow exponentially well into the future. You will ideally be able to delay much of your investment taxation into the future when you are in a lower tax bracket. Perhaps this will be when you are retired or strategically in years where your overall taxable income is artificially low.
How Valuable is Tax-Loss Harvesting?
When done right, tax-loss harvesting can have a positive effect on your net after-tax investment returns. The great thing here is that you can potentially earn better investment returns without having to take on any more investment risk.
How valuable tax-loss harvesting is for you personally will likely depend on the size of your accounts, as well as your income tax brackets. Likewise, the benefits of tax-loss harvesting will vary from year to year. When Donald Trump helped the stock market drop nearly 20% at the end of 2018, the benefits of tax harvesting were huge. (The overall stock market, has rebounded quite nicely, here in 2019). In other years when the market seemed to be just going up and up, there may not have been as many tax losses to harvest.
Over the years, I’ve read may studies and whitepapers estimating the value of tax-loss harvesting. The estimates mostly put the value of tax-loss harvesting somewhere between 0.50% and 2.54% averaged per year, over the long term. The value to you in any given year will likely vary. Even at the low end of this range, the benefits your investment returns can be substantial.
Can I Do Tax Loss Harvesting Myself?
Yes, tax harvesting is something anyone can do. But as I’ve mentioned above, it can get quite complicated and labor-intensive. Especially if you are dollar-cost averaging into your account – buying into your investment a bit each month. I’ve also seen many people run afoul to the tax-loss harvesting wash sales rule, lowering or even eliminating all their tax benefits.
If you are working with a financial advisor, as them to do it for you, if they blow you off or tell you that they aren’t able to help, well, this may be a sign it is time to find a better financial advisor. This service should be part of the financial advisor’s overall fee. You should not have to pay them anything else specifically for tax-loss harvesting. Depending on where your assets are being held, you may incur some transaction cost for buying and selling off holdings.
While you may be thinking, great one more thing to worry about, this doesn’t have to add stress to your life. Talk to your financial advisor, hopefull, they are already taking care of this for you. If not, you have some great opportunities to pay less in taxes this year. If you ask me, paying a less in taxes is worth a bit of hassle. Granted, I’m a total money nerd and truly love all this stuff.