In an alternate universe, perhaps far, far away, there may be markets where no one experiences loss, tax doesn't eat away at your earnings and investments always grow.
In our world, we know better. While we expect markets to climb over time, periodic downturns happen, and they can leave you feeling left out in the cold. But is it possible to pay fewer taxes and boost investment returns?
Our answer? Look for opportunities to leverage turbulent markets through year-round, tax-loss harvesting.
Tax-Loss Harvesting: An Overview
The concept of tax-loss harvesting is relatively simple, but the general goal is two-fold:
- Realize a loss for tax purposes. Sell assets at a loss and use the losses to offset taxable gains on other investments.
- Keep those assets in the market according to your investment plan. Buy a similar holding until you can reinvest as intended while avoiding the IRS’ “wash sale rule.”
Tax-loss harvesting is not about abandoning your carefully crafted asset allocations by panic-selling a losing holding. It’s about achieving an available tax-break, while sticking to your disciplined investment strategy throughout.
What Is the Wash Sale Rule?
It's important to use caution when choosing "similar" funds. You cannot claim a loss on a sale if you buy the same security (or a “substantially identical” one) within 30 calendar days before or after the original sale.
If the temporary replacement is "substantially identical," the IRS’ "wash sale rule" will disallow the loss for current income tax purposes.
The rule is less about being able to claim a legitimate loss on a failing stock, and more about discouraging people from selling a security solely for the tax benefit.
What is "substantially identical?" There are no explicit rules, but it's fair to say the exact same stock would qualify, as well as trading one S&P 500 mutual fund or ETF for another.
There are several mutual funds and ETFs that make good substitutes for one another from a practical perspective.
A Tax-Loss Harvesting Illustration
Assume you purchase a fund for $10,000. Two months later, it’s trading at $7,000.
You can harvest the short-term, $3,000 loss (short-term, since the fund was held less than a year). With a 37 percent ordinary federal income tax, this can result in a $1,110 tax savings.
At the same time, you take the $7,000 from the sale and reinvest it in a similar (but not "substantially identical") holding. After 31 days, you can reinvest in the original fund. As long as the market recovers, you’ve lost nothing, while gaining a $1,110 tax break. If the price dropped further from the first sale, you can take that loss also.
There Is No “Tax-Loss Harvesting Season”
Because tax-loss harvesting is associated with tax-planning, many investors (and some advisors) treat it as a year-end task.
This is a mistake.
Losses can occur any time of year and vanish by year-end. On one hand, that’s great because it means your investments are no worse for the wear (if you remained invested).
If you skip the opportunity to tax-loss harvest when losses occur, you skip the chance to lower your tax bill while you’re at it.
How It Works (and How It Doesn’t)
According to Buckingham Wealth Partner’s Managing Director of Investment Strategy Kevin Grogan, “Most investors should do tax-loss harvesting as long as the loss is large enough.”
So, what is “large enough”?
Tax-loss harvesting opportunities are best considered on a case-by-case basis, but Grogan offers some starting points: For stocks, start with at least a $5,000 or 5% loss, and for bonds at least a $5,000 or 2% loss.
It makes little sense to harvest a tax loss if the trading costs erase the benefits.
For example, say your tax break would be $100.
You’re better off staying put if the transactional costs add up to $50 or more. Remember, you're selling the initial holding, reinvesting in a similar one, and repurchasing the original.
You cannot harvest losses from holdings in tax-sheltered accounts (such as IRAs or retirement plans). Since realized gains in these accounts are non-taxable to begin with, they cannot be offset with any losses.
Sometimes, it's best to remain seated if the market is volatile.
Remember, your goal for tax-loss harvesting is to sell at a loss and immediately invest in a similar (but not “substantially identical”) replacement holding. The idea is to then sell again and reinvest in your original holding after 31 days. This ensures your portfolio remains true to your greater wealth plans.
When planning to swap, aim for the replacement holding to be the same or lower than the price you paid for it. Why? Taxes.
If the replacement holding goes up in value, you’ll incur short-term taxable gains, which could cost you more than the losses will save you.
Because volatile assets can incur large gains or losses over short periods, tax-loss harvesting should be carefully executed when the market is unstable.
For example, we used tax-loss harvesting during the brief downturn during the 4th quarter of 2018. Depending on your individual holdings and your ability to focus on execution, it might not have made sense for you to do the same.
Why Are Short-Term Losses More Valuable?
Earlier, we mentioned the benefit of harvesting a short-term loss. Why? Again: taxes.
Short-term losses are first deducted against short-term gains that can otherwise be taxed at higher ordinary income tax rates.
Long-term losses are first deducted against long-term gains that are otherwise taxed at lower capital gains rates.
Simplified, short-term losses can be more valuable to your tax management efforts, especially if you are in a higher tax bracket.
Periodic market losses are inevitable and inherent to investing. With that in mind, we employ year-round tax-loss harvesting as part of our wealth strategy, while also ensuring that the tax-loss harvesting “tail” doesn’t inappropriately wag the portfolio management “dog.”
Do you have questions about your own tax-loss harvesting strategy?
Let us know.