Reaping the Advantages of Tax Loss Harvesting
Tax loss harvesting can be an incredibly powerful way to reduce your tax bill and keep more money invested and working for you. Tax loss harvesting involves realizing losses from your investment portfolio that can be used to offset gains from your portfolio, or even your regular income. While many people don’t like the idea of “locking in” losses, it can be a great benefit to your total portfolio.
Losses Offset Your Capital Gains
The IRS taxes your investment portfolio a little like a business. At the end of the year, you are taxed on your net realized gains – the difference between your capital gains and losses – meaning any capital losses directly offset your capital gains for the year.
Say you have two stocks: Company A and Company B. You bought them both a couple years back at $100 per share. Since then, Company A has hit a rough patch and is trading at $50 per share. However, Company B is doing great, and trading at $155 per share. If you sold one share of each, you would have a capital gain of $55 from Company B and a $50 capital loss from Company A. Since we are looking at the net number (gain minus loss), you only owe taxes on $5 of capital gains.
Losses Can Offset your Income Taxes
While offsetting capital gains is important, capital losses can save you even more money in certain circumstances. If your losses outweigh your gains, up to $3,000 of your losses can be applied to your ordinary income for the year. Since your marginal income tax rate is likely greater than the capital gains tax rate, this can save you even more money. Let’s go back to our hypothetical companies: If Company B was trading at $120 per share instead of $155, you would offset the $20 of capital gains, so you wouldn’t owe any capital gains tax this year, and you could offset $35 of your regular income.
If you have a large amount of losses – more than the combination of your capital gains and the $3,000 ordinary income limit – you can carry the losses forward indefinitely to offset future gains. The same rules will apply in the future, so you’ll be able to offset an unlimited amount of capital gains and up to $3,000 of ordinary income in any year.
Watch Out for the Wash Sale Rule
There are a couple of things you should watch out for. First is something called the Wash Sale Rule, which basically states that if you claim a capital loss on the sale of a security, you cannot buy anything “substantially identical” for 30 days following the sale. Substantially identical is, as you can imagine, a term of art, but it basically means there must be a real difference between the securities. For instance, if you sold an S&P 500 index fund, you wouldn’t be able to buy a different S&P 500 index fund. But a total market index fund, such as one tracking the Russell 3000, would be okay. Your spouse should also avoid anything substantially identical as any suspicious purchase by them could also disallow your loss.
At the end of the 30-day window, you can buy back into the original security, but watch out for short-term capital gains. If the replacement security went up during the period that you held it, those gains will be subject to short-term capital gains, which are generally taxed more heavily than long-term capital gains.
Other Things to Watch Out For
Aside from the Wash Sale Rule, you still need to pay attention to the day-to-day issues of managing your portfolio. The two that you will most likely want to pay the closest attention to are your asset allocation and any transaction costs that you might be incurring.
As always, your asset allocation determines your portfolio’s risk and return. You should think carefully about how you handle tax loss harvesting to avoid significantly altering the level and types of risk you’re taking. If your asset allocation is significantly altered, a relatively small tax benefit can have a large impact on your portfolio’s returns.
In that same vein, you will want to keep a close eye on transaction costs. Depending on how much it costs you to trade, you can easily eat up all or a good chunk of the tax benefits you’ll be getting.
One other consideration is how tax loss harvesting will impact your future tax bills. Harvesting your losses means you’re selling your high-basis securities and keeping your low-basis ones, so you’re basically deferring your capital gains. You could deal with this in a number of ways, most notably by donating your low-cost basis securities to charity directly or through something like a donor-advised fund. If you were going to make charitable contributions in the first place, this allows you to get even more tax benefits from those donations.
Tax loss harvesting can be a powerful tool for your portfolio, but it requires a nuanced approach. You have to keep an eye out for opportunities to harvest losses while avoiding the Wash Sale Rule and making sure the rest of your portfolio doesn’t suffer. Without proper monitoring, the advantages of tax loss harvesting can become a big disadvantage for your portfolio.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
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