Tax-Loss Harvesting: What Is It and How Can It Help You?

Managing your investment portfolio to minimize taxes can be a major part of your retirement and financial planning strategy. Have you ever heard the term “tax-loss harvesting?” The technique can help to maintain tax efficiency over time, especially as markets fluctuate.

What is Tax-Loss Harvesting?

Tax-loss harvesting is the method of selling some investments when they reflect a tax-loss, and then on the same day purchasing a similar investment to retain your diversification, risk, and allocation in the portfolio in a similar manner to the risk and diversity balance of your portfolio.

How Does it Work?

The stock market will always have movement from day to day. Because of this, sometimes, stocks you hold in your investment portfolio may drop in value. Different sectors may be affected at different times, depending on world events and economic changes (for more details, check out Callan’s Periodic Table of Investment Returns).

When a stock drops in value, it can be a good time to have your financial advisor engage in tax-loss harvesting for you.

The steps they would follow are:

• Identify the investments reflecting a tax loss.
• Purchase a similar investment as a replacement – this should happen on the same day to keep you fully invested.

Your portfolio would remain invested in a parallel stock, which means you would still benefit from market increases in that sector.

The IRS defines that the new investment must be similar, but cannot be exactly the same. It is imperative that your advisor understand the IRS Wash Sale Rules to make tax-loss harvesting transactions. These rules state that if you sell an investment at a loss, you cannot hold the same investment for the next 30 days or the tax loss will be disallowed. You may, however, purchase the original investment again after the 30-day period has expired.

Would This Be Beneficial for Me?

Losses generated from selling investments are generally considered capital losses. These losses are allowed to offset other capital gain income you’ve earned in the same year.

One major advantage of capital losses is to the extent the losses are larger than your capital gains in a given year, the IRS allows you to deduct a net capital loss of $3,000 toward your other income.

On top of that, any unused capital loss amount is carried forward to future years. Under current law, these can be carried forward as long as you live — there is no expiration. This can be a huge advantage since the losses can be carried over and used in future years when the stock market earnings may be more positive and you may have larger capital gains.

This technique also allows you to retain more of your future growth in the portfolio, by lowering capital gain income in future years. Keeping more of your investment growth even while taking advantage of volatile stock markets when they occur.

When Should Tax-Loss Harvesting Be Completed?

Tax-loss harvesting is sometimes thought of as an annual or year-end technique; however, it’s most valuable to help you achieve tax efficiency in your portfolio over time as the markets fluctuate or go through volatile periods. Using this method on a regular basis following the natural movement of market performance, you may retain more of the potential future growth when the markets turn around.

Tax-loss harvesting is particularly useful when markets may be down. The year 2020 presents a useful picture of how this approach can be used well.

Example of Tax-Loss Harvesting

On March 31, 2020, most equity indexes (stocks in the market) were reflecting negative performance. You might remember the uncertainty and confusion when COVID-19 hit the world stage.

Interestingly, even with a dire-looking situation in March of 2020, these same indexes finished the year strong. They had not only recovered but were in positive territory by the last day of 2020. A few example indexes are:

Source: Morningstar Direct

While that shows the difference in index changes, let’s look at a specific illustrative example someone might have experienced.

An investor owns ABC Mutual Fund purchased in January 2019 for $20,000. The value of that fund changed over time, and on March 31, 2020, was valued at $15,000. A financial advisor sold the shares of ABC Mutual Fund on behalf of that investor, and realized a capital loss of $5,000. On that same day, the financial advisor purchased the S&P 500 Index for $15,000, the same amount of dollars that were sold.

The results of this are:

The investor reports a capital loss of $5,000 on that year’s taxes. The investor is also still invested in a similar manner, benefitting from any future market rallies. The investor is also able, after 30 days, to repurchase the ABC Mutual Fund and avoid IRS Wash Sale rules limiting selling and repurchasing the same stocks in the same period.

In this example, the investor is allowed to take advantage of the dips in the markets by booking some temporary capital losses. At the same time, they are rotating into other investment positions still shaped around maintaining their long-term goals with appropriate allocations.

When the investor saw markets improve later in 2020, they captured the positive returns in the markets. They also booked realized capital losses in March, which were then able to be used against other capital gains realized in 2020, enabling them to keep more of the later market growth and reducing their tax payment.

Conclusion

Investing in a tax-efficient manner should consider the downward movements in the markets throughout the year to take advantage of possible tax-loss harvesting where appropriate. A financial advisor focusing on this can potentially help you pay less in taxes and keep more longer-term grown in your portfolio.

This is intended for educational purposes only and should not be construed as personalized investment or tax advice. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.

Angie M. Stephenson Financial Advisor / Managing Director

Angie has been involved in the financial services industry since 1995. She earned a bachelor of science degree in accounting from Concord University.