Managing your investment portfolio well to minimize taxes can be a major part of your retirement and financial planning.
Have you ever heard the phrase ‘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 are reflecting 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 will 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 will remain invested in a parallel stock, which means you 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, as there is no expiration. This can be a huge advantage as 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.
This method is particularly useful when markets may be down. The year 2020 is 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 the novel coronavirus 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:
1/1 through 3/31/2020 1/1 through 12/31/2020
S&P 500 Index Down (19.5%) Up 18.4%
Russell 1000 Value Index Down (26.7%) Up 2.8%
Russell 2000 Index Down (30.7%) Up 20.0%
While that shows the difference in index changes, let’s look at a specific example someone might have been through.
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 have passed, to repurchase the ABC Mutual Fund and avoid IRS Wash Sale rules limiting selling and repurchasing the same stocks in the same period of time.
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 someone in this example 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.
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 help you pay less in taxes and keep more longer-term grown in your portfolio.
If you’re looking to speak with an advisor to learn more about managing your investments in a tax-efficient manner or want to discuss a financial plan that will help you reach your goals, Domani Wealth has advisors ready to start a conversation. You can get in touch with us by calling 855-855-5455, emailing [email protected], or connecting with a team member directly.