It’s no secret that the stock mark can be volatile—especially in 2022. All too often these days it seems we watch the market fall, then rise, then fall again all within the span of a few hours. When it comes to the dynamics of the market, we love the gains and fear the losses.
But market declines are a reality, and when they happen, a unique opportunity comes knocking. There is usually a 5% drop in the market about 3-4 times a year, a 10% drop annually, and about every 5-6 years, we see it drop 20% from a bear market. So, where is the opportunity in all of these market drops? Your tax bill.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy that can allow you to offset your losses with a reduced tax bill. In general, you tax-loss harvest when you sell an investment at a loss with the goal of offsetting current or future capital gains realized on your other investments and/or ordinary income. By doing so, you may be able to substantially reduce taxes owed on those realized gains as well as lower your taxable income by as much as $3,000 per year.
How Does it Work?
When you sell an investment for profit, you realize a capital gain. Federal tax on short-term capital gains can be as high as 37%, and federal tax on long-term capital gains can be as high as 23.8 % (that’s the maximum 20% long-term capital gain rate plus the 3.8% Medicare surtax).
In practice, tax-loss harvesting typically involves strategically selling an investment at a loss and then almost immediately purchasing an investment that is similar to—not identical to—the one you sold. Through these actions, you can both reduce your tax liability and give yourself the ability to be strategic with future gains, all while maintaining your target investment exposure.
There are, of course, some rules governing tax-loss harvesting that you’ll want to know.
Tax-Loss Harvesting Rules
1. Your investment needs to be in a taxable investment account.
Some investment accounts, like your 401(k) or IRA, are tax-advantaged accounts. The IRS doesn’t charge capital gains tax on investments held in those accounts and are ineligible for tax-loss harvesting.
Therefore, tax-loss harvesting is something you would consider only when you have a taxable investment account, like a brokerage account.
2. You can’t buy the same investment for at least 30 days before or after you sell.
If you sell an investment at a loss with the intention of writing down your taxes through tax-loss harvesting, you can’t purchase the same or an identical investment 30 days before or after the sale. This is known as the “wash sale” rule. The wash sale rule provides a framework to harvest losses and maintain market exposure instead of simply selling the original security and holding cash in the portfolio.
Because of the wash sale rule, if you want to maintain exposure to the market, you might buy a similar investment for that 30-day period. After the 30-day period, you can either continue holding the similar investment or go back to the original. But keep in mind, if the gain on the similar investment is greater than the harvested loss, you may not want to revert to the original investment.
3. Current-year losses must be harvested by Dec. 31st.
While leveraging tax-loss harvesting for the current year requires sales to be finalized by Dec. 31st, tax-loss harvesting should not be viewed as a year-end activity. Instead, it’s best to keep the strategy top of mind throughout the year. Any time there is a market downturn or you rebalance your portfolio, there is opportunity to take advantage of tax-loss harvesting. If your assets are managed by a financial advisor, tax-loss harvesting may already be an integral component to their investment strategy.
4. Calculate your net capital losses.
As stated earlier, short- and long-term gains are taxed at different rates. Short-term gains, which are taxed like ordinary income that you earn from your job, can be taxed as low as 10% or as high as 37%, depending on your tax bracket.
Considering how differently capital gains are taxed, there are rules (as you might expect) around how your capital losses are calculated. The federal tax code says that losses must first be applied to offset gains of the same type. However, if your losses of one type exceed your gains of the same type, you can then use those losses to offset the other type of gain. If your total losses exceed total gains, then you have a net capital loss.
After determining your net capital loss, the federal tax code allows you to offset ordinary income, which is taxed at the same rate as short-term gains.
5. There’s a limit to how much ordinary income you can write down in a year.
As mentioned above, there’s a limit to how much you can reduce your ordinary income each year through tax-loss harvesting: $3,000 per year for individual filers or married couples filing jointly, or $1,500 per person per year if you are married filing separately.
6. Use the power of tax-loss carryforwards.
When you have losses in one year that substantially exceed your gains and the $3,000 write-down limit on ordinary income, you can carry over these losses into future tax years. These are called “tax-loss carryforwards,” and they are powerful tools. Not only do they enable you to offset future capital gains, but they also enable you to reduce your ordinary income by as much as $3,000 per year. What’s more, your tax-loss carryforwards expire only once you’ve fully exhausted all your losses.
Tax-Loss Harvesting in Action
Let’s illustrate how you can unlock the power of tax-loss harvesting through a hypothetical example.
John Wells is a doctor who files as a single taxpayer. This past January, Wells decided to invest $500,000 in an index fund with the intent of holding it indefinitely. Two months later, the index lost 30% of its value, shrinking his investment to $350,000.
While March was a rough month for Wells, his investment thesis hadn’t changed, and he fully expected the market to recover. So, Wells sold his investment at a 30% loss and immediately reinvested the proceeds in a substantially similar (but not identical) fund, maintaining his desired market exposure.
As the market recovered in the future, Wells reaped the benefits of holding his investment as originally intended, but he also secured $150,000 in short-term losses to offset other realized gains and/or up to $3,000 of his ordinary income this year (and, potentially, in future years).
Wells’ strategy pays off a few months later when he decides to sell a tech investment that is worth $200,000. He’d originally purchased it for $100,000, and he will now owe taxes on his $100,000 long-term capital gain.
However, since these were Wells’ only transactions, Wells was able to avoid paying capital gains tax on the $100,000 profit from his tech stock sale year through the tax-loss harvesting technique. Additionally, he applied $3,000 of his losses as a deduction toward ordinary income and carried forward an additional $47,000 of short-term capital losses for future years. He can apply that $47,000 in losses to offset future realized capital gains and/or reduce his ordinary taxable income by as much as $3,000 each year until it is exhausted.
Is it Worth it?
While it depends on your situation and financial goals, if you have a significant amount of assets held in taxable accounts, tax-loss harvesting can be a powerful component of your financial plan and investment portfolio. Effective use of tax-loss harvesting can enable you to both better manage and reduce your tax liability over the long term, helping boost your investment returns.
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Brad Lyons, CFP®