Conventional investing advice tells us to avoid selling investments at a loss. However, sometimes there are benefits to releasing some of your holdings back into the wilds of the market, even if temporarily. Tax-loss harvesting can help.
What is tax-loss harvesting?
Tax-loss harvesting (TLH) is a portfolio management strategy that involves selling investments at a loss in order to offset capital gains on other investments or to lower your overall taxable income. When done right, this technique adds balance to your portfolio, and may even help you buy new investments, retire earlier, or possibly leave a larger legacy to your heirs.
How much in capital gains can you deduct each year?
Tax-loss harvesting can be used to either decrease capital gains taxes or offset ordinary income, but the IRS limits how much you can deduct annually.
Capital gains annual deduction limits
- Single filers and married couples filing jointly can deduct a maximum of $3,000 annually in realized losses from ordinary income.
- Married couples filing separately can each deduct $1,500 annually.
What else do I need to know about tax-loss harvesting?
Know your cost basis
Your cost basis is what you originally paid for an investment. Finding this value is easy if you only made one purchase. In such a case, your one-time investment serves as your cost basis. However, if you invested in a security over a period of time, as one does with dollar cost averaging, arriving at your cost basis will be a bit more challenging.
To find this number, you’ll need to know a couple things:
- The dates you purchased each share.
- The value of each transaction.
Once you have these facts, you can calculate the gain or loss and parse which ones classify as long-term (more than a year) or short-term (less than a year) capital gains.
Wash sale rule
Since tax-loss harvesting can present opportunities to buy new investments that may provide better performance, investors will typically purchase similar types of securities to the ones they sold to keep their risk levels and asset allocations consistent.
But there's a rule that prevents investors from selling depreciated securities and replacing them with either the same or "substantially identical" investment within 30 days before or after the sale. The IRS calls this the wash-sale rule, which prohibits investors from writing off investment losses that could potentially raise their taxes for the year.
The term "substantially identical" does not prohibit investors from buying investments in the same industry. So, for example, you can sell your shares in United Health and replace them with Blue Cross Blue Shield stock. This is also the case for mutual funds and ETFs that benchmark the same industries.
Taxable accounts only
Your retirement accounts, such as 401(k)s and IRAs, cannot be used to harvest losses. That's because they are tax-deferred, meaning they grow tax-free until you take a distribution (withdraw). Even if you have losses in a retirement account, the IRS treats these differently than taxable accounts, rendering TLH useless.
A final note: You must make all transactions in the tax year you wish to harvest losses. So, if you want to harvest losses from 2022, your transactions need to clear by December 31, 2022.
How does tax-loss harvesting work?
To make TLH work, you have to sell depreciated investments (losers) to cancel out realized gains (winners) on investments you sold at a profit. By doing so, you only owe taxes on your net profit, which is found simply by calculating the following:
Amount gained - Amount lost = Net profit
Here’s a hypothetical example to illustrate how TLH works:
Let's say in March you bought 50 shares of Hudu stock, an up-and-coming streaming service, at $50 per share for a total of $2,500. Unfortunately, by November of that same year, Hudu plummets to just $5 a share, leaving you with a mere $250 in current market value.
Knowing that your investment in Hudu was a risky one, at the same time, you also invested $10,000 in streaming giant, FlixMax, to hedge your bets. Unlike Hudu, this investment went up by 30%—representing a $3,000 gain—leaving your current market value in FlixMax at $13,000.
Since 30% is nothing to sneeze at, you decide to sell your stake in FlixMax and realize your $3,000 gain. However, since you realized your gain in less than a year (short-term gain), you will owe ordinary income tax on your profit. So, you sell your losing investment in Hudu to offset some of this gain.
But how much of this gain can be offset?
Let's go back to our net profit formula above.
Amount gained: $3,000 ($10,000 + $3,000) - Amount lost: $2,250 ($2,500 - $250) = $750.
By harvesting your losses, you lowered your tax burden from $3,000 to $750, or 75%.
Who can benefit from tax-loss harvesting?
It’s important to note that tax-loss harvesting is not reserved for just the wealthy. Everyday investors can also benefit.
Virtually anyone can benefit from tax-loss harvesting, unless you are a single filer that earns less than $40,000 or a joint filer that makes less than $80,000. In this case, you will owe nothing on long-term capital gains.
When is the best time to harvest losses?
When markets are down, opportunities arise for investors to make targeted investment changes, rebalance their portfolios, and take advantage of tax loss harvesting to ensure they take the right amount of risk for their situation.
For example, suppose an investor has a concentrated single stock position or an investment producing more volatility than expected. In that case, a falling market may be an opportune time to diversify.
One way to do this is to swap out more volatile investments and replace them with a more diversified mix. This presents the option to either realize a tax loss or at least do so with a lower tax burden than would have been possible a year ago.
Final word
Harvesting losses the right way can be challenging, so it’s best to seek the help of professionals to get it right and avoid any setbacks. To get the most out of tax-loss harvesting (and preserve your sanity), consider consulting a team of experts who live and breathe this stuff.
Want to learn more? Look no further than Facet. See how our investment management program is designed to maximize your success and achieve your desired outcomes.
