On the surface, you might not think investment losses play a pivotal role in your ongoing tax planning strategy. After all, you want to increase your returns, not minimize them. But making the most of your losses and turning them into strategic opportunities can actually help you if you know what to do. Let’s review a common, yet often under-appreciated tax strategy for high earners: tax loss harvesting.
What Is Tax Loss Harvesting?
When you have a broadly diversified portfolio, you’ll most likely have many different investments, and not all of them will be performing well 100% of the time. Part of having a diversified portfolio means taking the bad with the good. In other words, if a certain fund or stock is doing poorly, an investor’s tasked with the job of making lemons out of lemonade.
Instead of doing nothing, you could use the losses from these investments to reduce your tax bill. But how?
Tax loss harvesting allows you to sell underperforming assets at a loss, and use that loss to offset profits made on other assets.
You might be asking why you would want to accept loss to reduce your gain. Isn’t that counter-productive?
In this case, not really. The key distinction here is that you aren’t intentionally creating losses – that would in fact be counter-productive. Instead, you are strategically realizing the occasional isolated losses that are an inevitable part of a disciplined investment strategy in a way that ensures you don’t overpay on your tax bill, come April.
What Tax Loss Harvesting Could Look Like In A Portfolio
For this example, let’s pretend we’re working with a hypothetical person named Taylor.
One of Taylor’s long-term investments in their taxable brokerage account appreciated significantly over the past year, and is up from $100,000 to $125,000. They want to sell it, but if they do so they’ll need to pay long-term capital gains tax on the $25,000 gain.
However, Taylor also has another investment that is experiencing a down year and has lost $20,000.
This is a good opportunity to employ tax-loss harvesting. If Taylor sells the poor investment in addition to the appreciated investment, then the $20,000 realized loss can offset the $25,000 gain. Taylor would only owe taxes on a $5,000 net long-term capital gain.
Additionally, if Taylor had other losses to harvest, they could offset the entirety of their gains and pay no tax on them. In this example, they would need to realize another $5,000 loss to completely eliminate their capital gain tax liability.
Now let’s flip the example to understand what it would look like if Taylor’s losses were more than their gains.
Let’s say they had one investment gaining $20,000, but one with a loss of $25,000.
They would use the $25k loss to fully offset the $20k gain, and another $3k (if they were married and filing jointly, $1.5k if they were filing as single) toward ordinary income, leaving $2k to roll over to the next year.
When Tax Loss Harvesting Makes Sense
A major component of ongoing tax-loss harvesting is selling something and buying a similar fund to keep its place for the 30-day period, then either leaving it alone or jumping back to the original.
The reason for doing so is to not miss out on a market or fund rebound by taking the loss on your investments. This way, you’ve taken the loss to offset any gains, but continue to remain invested so that you don’t miss any market action, and stay on track with your allocation.
Rules High Earners Must Keep In Mind: The Why Behind a 30-Day Purchase Window
While tax loss harvesting is a great tool, there are some important aspects to consider before you take any action.
Perhaps the most significant misstep to watch out for is the wash-sale rule. You might think about selling an investment at a loss and buying it back soon after, but the IRS has a rule to ward against this called the wash-sale rule.
A “wash sale” occurs when the purchase and sale of the investment occur within 30 days of each other. If you sell an asset at a loss and buy one that’s “substantially identical,” within this timeframe then the loss is disallowed for tax purposes and cannot be used to offset gains.
We mentioned earlier selling and then buying a similar fund. Let’s take a look at this through the lens of the wash sale rule.
You will not be able to make a move such as selling a Vanguard S&P 500 Institutional share class and buying their Admiral share class – those are substantially the same. But you could consider going from Vanguard S&P500 to iShares S&P500. These are totally different fund companies. Working with a professional to make sure you’re employing the rules to tax loss harvesting will be critical to your financial success.
In Highs and Lows
When considering when to use this strategy, note that it is particularly beneficial when the market is down. This is because you can “prune” your investments, so to speak, and reduce your taxes when applicable.
Conversely, you may employ tax loss harvesting if you’re experiencing an unexpected gain or a high-income year from a windfall, liquidity event, or profitable equity comp. This way, realizing losses can help keep your tax situation at bay. Doing so is a great way to maintain balance and diversity within your portfolio.
Also, keep in mind that tax-loss harvesting shouldn’t drive your investment decisions. You need to be mindful of your risk levels within your portfolio. Will buying and selling put your portfolio out of balance for your desired risk levels? Is there a suitable replacement for the investment you sold? Consider these questions before deciding to harvest losses. If the answers aren’t favorable, you probably shouldn’t do it.
Using Similar Funds
One more rule about tax-loss harvesting: short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type.
For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, these are both in the “long-term” category. But, since you have a remaining $10,000, you could then apply this excess to offset any short-term gains.
Keeping this simple rule in mind will allow you to better understand when and how to use this tax strategy.
Get Help With Tax-Loss Harvesting
Overall, when deciding whether or not to harvest gains and losses, it’s important to not think about your investments in a vacuum. Consider your overall tax bill, and your portfolio as holistically as possible. In general, harvesting makes the most sense when you are in a less favorable tax situation and might end up paying more than usual.
We’re here to help you strategize this tax season and make your money work for you. Call us today to review your investments and see if there are tax-loss harvesting opportunities waiting for you.