Usually, the word "loss" is something we try to avoid when looking at our finances. However, in a smart financial roadmap, a strategic loss can actually be a gain in disguise. By understanding how to use market dips to your advantage, you can keep more of your hard-earned money working for you rather than handing it over to the IRS right away.
Investments and taxes
To understand this strategy, we first need to look at how money is taxed. Just as you pay taxes on the income deducted from your paycheck, you also usually owe taxes when your investments make money. However, there are two key differences.
First, the tax rate on investment gains is usually lower than the taxes on your regular income. Second, if the value of an investment drops, that loss can often offset gains in other investments.
The taxes you pay on investments are called capital gains taxes. Put simply, you pay taxes on the gain, or the increase, in the value of an investment you purchased with capital. Keep in mind that this mostly applies to taxable accounts. Many retirement plans, such as a 401(k), 403(b), IRA, or Roth IRA, either defer or eliminate taxes until you start taking money out.
How tax-loss harvesting works
TLH involves selling depreciated investments to void out realized gains on investments you sold. This results in taxes owed only on the net profit. The formula is simple: Amount gained minus Amount lost equals Net profit.
Here is a practical example. Say you own 100 shares of stock in Company A and another 100 shares in Company B.
If Company A's stock is now worth $1,000 more than when you bought it and you sell those shares, you will owe capital gains taxes on that $1,000 gain. Now, imagine Company B's stock is worth $1,000 less than you paid. If you sell both at the same time, the $1,000 capital gain from Company A is offset by the $1,000 loss from Company B. The result is that no capital gains taxes are due.
Using ETFs to harvest losses
This strategy also works for mutual funds and exchange-traded funds (ETFs). Let's say a specific ETF costs you $10,000. The IRS calls this your cost basis. If the ETF drops in value to $8,000, you can sell it and immediately buy a similar ETF so you stay invested in the market.
Your new cost basis is $8,000. The $2,000 loss you realized by selling the first ETF can now be used to offset gains on other investments.
The benefit of deferring taxes
You might wonder if this just delays the inevitable. If you sell that second ETF in the future, you will pay taxes on the gain then. However, because of inflation, paying taxes in the future costs you less than paying them now.
Let's look at the math on that previous example. You realized a tax loss of $2,000. If your capital gains tax rate is 20%, TLH saves you $400 in taxes initially.
Say you sell that replacement ETF in 10 years. You will have to pay that $400 then. But in this hypothetical example, if inflation averages 3% a year, this would result in an inflation-adjusted savings of $102 in taxes.* This is because, after inflation, $400 in the future is worth less than it is today. The tradeoff of paying taxes in the future leverages inflation to save you money.
*Hypothetical results are for illustrative purposes only and do not represent actual client experiences. Actual results will vary based on market conditions, tax rates, and individual circumstances.
Why Facet manages this for you
Tax-loss harvesting may seem complicated, and timing is critical to getting it right. At Facet, we believe you shouldn't have to pay extra fees to take advantage of smart tax strategies. Our investment management team manages TLH for every member account at no extra charge to help optimize the tax efficiency of your portfolio. We handle the complexity so you can feel confident your money is working as hard as possible.
