When is a loss actually a gain? When investments are managed to take advantage of tax laws using a strategy called tax-loss harvesting.
The word “loss” in tax-loss harvesting (TLH) actually has several short-and long-term benefits for investors, which is why TLH is an integral part of Facet’s investment experience.
Here’s how investments are taxed, how TLH can benefit investors, and the one tradeoff to using this strategy.
Investments and taxes
Just as you pay taxes on the income you receive, generally deducted from your paycheck, when your investments make money, you’ll also usually owe taxes.
There are two key differences:
- In most instances, the tax rate on investment gains is lower than the taxes on your income.
- If the value of an investment drops, that can offset gains in other investments in many circumstances.
The taxes you pay on investments are called capital gains taxes. They’re very different from the income taxes that come out of your paycheck. Put simply: you pay taxes on the gain (increase) in the value of an investment that you purchased with capital (money).
Keep in mind that this mostly applies to investments that are subject to taxation. Many retirement plans either defer or eliminate taxes.
If you have money in a workplace retirement account, such as a 401(k) or 403(b), or have an IRA or Roth IRA, taxes won’t be due until you start taking money out, and in some cases, not even then.
How does tax-loss harvesting work?
TLH involves selling depreciated investments (losses) to void out realized gains (profits) on investments you sold.
This results in taxes owed on only the net profit (if any).
Here’s the formula to find your net profit:
Amount gained - Amount lost = Net profit
For 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’ll owe capital gains taxes on the gain of $1,000.
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 you realized when you sold Company A’s stock will be offset by the $1,000 you lost when you sold Company B’s stock.
The result: no capital gains taxes are due.
TLH works similarly for gains and losses in mutual funds and exchange-traded funds (ETFs).
Here’s an example:
Let’s say that a specific ETF costs you $10,000. The IRS calls the $10,000 you paid for that ETF your cost basis: the basis used to calculate potential gains, losses, and taxes.
If the ETF drops in value to $8,000 and you sell it and buy a similar ETF, your cost basis will be $8,000.
The $2,000 loss can be used to offset gains on other investments.
So, if the second ETF increases in value and you sell it in a year or two, you’ll pay taxes on that capital gain.
But because of inflation, paying taxes in the future will cost you less than paying taxes now (because inflation erodes the value of a dollar).
Put another way:
- You own ETF A with a cost basis of $10,000 and a market value of $8,000.
- You sell ETF A for $8,000 and buy ETF B, which is identical to ETF A. You realize a tax loss of $2,000. The new cost basis of this allocation is $8,000.
- If ETF B is sold in the future, you’ll realize $2,000 more in capital gains than had you kept ETF A.
What’s the benefit of TLH?
Here’s the benefit of tax-loss harvesting. Say you sell ETF B in 10 years, and your capital gains tax rate is 20%.
TLH will save you $400 in taxes initially. You’ll have to pay that $400 in 10 years, but you’ll still save, thanks to inflation.
In this hypothetical example, if inflation averages 3% a year, you’ll actually save $102 in taxes because, after inflation, $400 in the future is worth less than it is today.
So the tradeoff of paying taxes in the future, rather than the present, leverages inflation to save on taxes.
Tax-loss harvesting may seem complicated, and timing is critical. The investment management team at Facet manages TLH for every member account at no extra charge to ensure members receive the maximum tax benefits from their investments.
