The first rule of investment is never lose your capital.
This notion is deep-seated among investors, and there are a variety of tools and strategies which are focused on minimizing risk and reducing losses.
However, not all losses are bad. Sometimes an investment that has lost value can still help your portfolio.
One way an investment loss can be harnessed to your advantage is tax-loss harvesting.
Experienced investors and portfolio managers have used this strategy to lower taxes on their profits, thereby boosting portfolio returns. This article sheds a spotlight on tax-loss harvesting, how it can be applied, and its pros and cons.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a practice which investors use to reduce the amount of tax they owe on their capital gains or regular income.
This is done by selling securities at a loss to offset profits made by selling other stocks at a profit. As a consequence, the investor only gets to pay taxes on their net profit, thereby lowering the tax burden.
6 Ways Tax-Loss Harvesting Works
1. Applicable to only taxable accounts
The premise behind tax-loss harvesting is to offset taxable investment gains.
But this only applies to taxable accounts. The IRS does not tax capital growth on investments held in tax-sheltered accounts such as 401(k)s, 403(b)s, IRAs, and 529s. As such, if your investments are held in such accounts, you do not need tax-loss harvesting.
2. Not worth it if you’re in a low tax bracket
Tax-loss harvesting favors those in a higher tax bracket.
This is because the amount saved would be much more significant for those who earn more, than for those who earn less. If you are in a low tax bracket, you may want to put this strategy on hold until you climb the income ladder.
Alternatively, you may practice and fine-tune this strategy in preparation for when you join the high rollers and start earning big.
3. Only eligible for the current year
It is important to bear in mind that sales of securities must be completed before the end of the tax year if you want to harvest losses and reap the benefits they provide.
For example, If you wanted to harvest losses from 2022, transactions have to be concluded by December 31, 2022.
4. Useful for stocks, actively managed funds, and/or ETFs
It is often difficult for index fund investors to implement tax-loss harvesting in their portfolios.
It’s a different scenario if you’re indexing using ETFs or mutual funds that specialize in a certain sector or theme.
This is when using a Robo-advisor to invest comes in handy. Robo-advisors do a lot more for their clients than just design and maintain well-balanced portfolios. Most of them also work as tax police, as they are always on the lookout for ways to reduce taxes and offset earnings 24 hours a day, seven days a week.
5. Holding period matters
The taxes you pay on gains are based on the length of time you’ve owned the investment.
This implies that tax-loss harvesting would be more profitable for investments with long-term capital gains (investments held over a year), than those held short-term (less than a year).
6. Keep your records straight
The IRS always double-checks your tax filings, so be sure to fill in the accurate information when filing your taxes. When you file Schedule D to record your capital gains and losses, the IRS double-checks your work.
4 Limitations to Tax-Loss Harvesting
There are certain limitations to the effectiveness of this strategy due to regulations put in place by the Internal Revenue Service (IRS).
1. Wash-Sale Rule
A wash sale occurs when you sell securities at a loss and within 30 days before or after the sale you purchase the same or substantially identical security.
IRS regulations prohibit taxpayers from engaging in wash sales, and would ultimately reject a request for tax deduction from such investors.
One technique for replacing an individual stock that loses value with a mutual fund or ETF that targets the same industry for investors who wish to harvest their losses while avoiding any wash-rule breaches is to replace it with a mutual fund or ETF that targets the same industry.
This will help you to keep your portfolio’s asset allocation consistent.
2. Tax Liability Threshold
There is a limit for realized capital loss, which can be used to reduce your taxable income.
As a result, there is a threshold at which you can harvest capital losses to boost portfolio gains. This may be disadvantageous for those in a higher tax bracket. However, the IRS allows for additional losses to be carried forward for use on future tax returns.
3. Administrative Costs
Tax-loss harvesting is a complicated process that requires the expertise of tax accountants and financial advisors.
As a result, it incurs administrative costs to the investors which if not understood, could defeat the initial purpose – saving money. The rule of thumb as regards tax-loss harvesting is that you should only harvest the loss if the tax benefit outweighs the administrative cost.
4. Portfolio Rebalancing as a strategy for tax-loss harvesting
If you can do it while rebalancing your portfolio, that’s one of the finest circumstances for tax-loss harvesting.
Rebalancing your asset portfolio might help you achieve a better balance of return and risk. Consider which holdings to acquire and sell as you rebalance, and keep the cost basis in mind (the adjusted, original purchase value).
The capital gains or losses on each asset will be determined by the cost basis. This method prevents you from selling for the sole purpose of realizing a tax loss that may or may not be appropriate for your investment plan.
The Bottom Line
Tax regulations allow for the tax-loss harvesting approach to be used as an investing strategy.
Tax savings, on the other hand, should never detract from or obstruct your investment objectives. This method can enhance your after-tax returns in some instances, allowing you to accumulate assets faster.
The ideal method, however, may be to follow a balanced plan and examine your portfolio regularly to ensure that all of your assets are in accordance with your goals.
Photo by Iryna Tysiak on Unsplash
