What Is Tax-loss Harvesting?
Tax-loss harvesting is an investment strategy that seeks to reduce the amount of taxes owed by selling investments that have dropped in value.
How Does Tax-loss Harvesting Work?
This is an example of tax-loss harvesting in action:
Let's say you invest $10,000 in a mutual fund. One year later, you're sitting on $11,000 worth of gains… just short of the $12,000 maximum that would trigger taxes.
If you sell your entire position to harvest your losses, then re-buy it (so your total investment stays at $10,000), you'll be able to report a loss for tax purposes, and thus only pay taxes on initial gain ($1k)… not the total amount ($11k).
This strategy can be applied to individual securities as well. Let's say you have a stock that you've held for several years, but its value has dropped significantly since your purchase. This could indicate that it's time to sell your position… but before doing so, consider tax-loss harvesting. By selling the stock at its current market price, then "buying it back" after 30 days (the IRS requires this waiting period), you'll be able to report a capital loss and thus offset gains from other investments or reduce your taxable income.
Update: You will only realize a capital loss when selling an investment that has gone up in price and thus creating a taxable gain on your books. If you sell shares at a loss, this will create a capital loss that can be carried forward to offset potential gains in the future.
What Are The Requirements For Tax-loss Harvesting?
You must be an informed investor:
You must know which of your investments are likely to appreciate in value and be able to differentiate from those which are likely to lose value. This is an important part of financial planning.
You must have capital gains:
This isn't something you can do every year, as the strategy works best if your investments have appreciated in value since purchase… thus triggering a capital gain that you could offset with a loss harvested from another investment. The IRS allows individuals up to $3000 in losses without documenting them, but this shouldn't be your primary source of tax-advantaged savings.
You cannot harvest more than $3000 worth of loss per year:
You can repeat this process multiple times throughout the calendar year, but only up to $3000 total for each account (e.g., bank account, brokerage account, or retirement account).
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What Is The Impact On Your Portfolio?
Tax-loss harvesting shouldn't have a significant impact on your portfolio. If you're investing in mutual funds, ETFs, stocks, etc., then it's very unlikely that harvesting will cause the value to go down by more than 3%. Even if you use individual securities for this purpose, there should be no greater impact on your portfolio's overall performance.
Tax-loss harvesting simply allows investors to take advantage of market volatility without triggering significant capital gains… which would otherwise go to the government rather than being put back to work for you. It also allows investors who are sitting on unrealized losses (where their total position is worth less than what they paid) to sell and take advantage of the loss without having to document it (which would trigger reporting requirements in some cases).
How To Get Started With Tax-Loss Harvesting?
If you'd like to give tax-loss harvesting a try, then we recommend using an online broker that automatically tracks your gains and losses. This is standard practice for most discount and robo-advisors.
For example: Vanguard will track your adjusted cost basis, which is required by law. If you don't have access to such a service directly, many robo-advisors offer this feature as an add-on. And if you're investing with an advisor, be sure they either do the same or are willing to work with you on handling this process manually.
If you don't currently have a strategy in place to document your capital gains/losses, then the easiest way to get started is by using an automated tool or roboadvisor to help you manage that process.
Harvesting Larger Losses
As with any investment strategy, tax-loss harvesting isn't always the right move. For example, if your taxable income falls under $100k ($200k if married filing jointly), then tax-loss harvesting adds no benefit because it won't reduce your tax burden at all. It also works best for net long-term capital gains. Short-term gains are taxed at the same rate as ordinary income, so there's little point in trying to avoid them when you're paying 0%.
In some cases, harvesting larger losses can actually have a negative impact on your long-term returns.
This is because there is a small amount of opportunity cost to tax-loss harvesting, as you might otherwise invest the money in another investment… which could provide an additional return over time. In most cases, this opportunity cost isn't significant enough to have a negative effect on your portfolio's overall performance… but it's something that you should keep in mind when evaluating an opportunity for harvestable losses.
If your total annual income is under $60k ($120k if married filing jointly), then the loss harvesting strategy has no benefit (since you're not paying any taxes anyway). And if it leads to selling off securities at a loss, the loss could be subject to capital gains taxes down the road… which might reduce your portfolio's long-term value.
These scenarios highlight why tax-loss harvesting is typically not a good strategy for younger investors: They generally have less money and thus can't afford to purchase significantly more securities to offset potential losses harvested from their current holdings (which also limits opportunity).
Keeping Your Losses Intact
If you're already investing, then one of the best ways to add tax-loss harvesting to your strategy is by taking advantage of opportunities that present themselves when rebalancing your existing portfolio.
Many robo-advisors and traditional investment advisors will offer this service as part of their standard package, while some brokers will provide it at a nominal cost.
One of the benefits that you get with a robo-advisor is that they make it easy to implement tax-loss harvesting as part of your investment strategy since it's all done automatically. All you have to do is make sure that your broker or advisor has a feature in place to enable this process for any securities where a loss has been identified… and then let them do their thing.
In most cases, rebalancing opportunities will come from cash flows into your portfolio (which can be used to buy additional assets). In some cases, if there are no appropriate purchases around… then simply using dividends as additional cash can help offset any potential losses harvested from existing holdings.
What If You Don't Rebalance?
Tax-loss harvesting is intended to be part of an overall strategy, not the entire plan. Just like working out at the gym helps you better enjoy your favorite foods… but won't get rid of excess body fat without accompanying dietary changes; tax-loss harvesting works best when it's supplemented with smart investment practices (like rebalancing).
If you let taxable profits ride, then there's no reason for harvesting losses in the first place. There are certain situations where this isn't possible (or advisable), but by letting profits ride you will eventually reduce your cost basis over time. This effectively makes it pointless to try and harvest losses when they occur… since doing so doesn't increase the amount of gains that can be harvested when you eventually sell.
There's also an argument to be made that the best way to take advantage of tax-loss harvesting is simply by investing in highly diversified portfolios (and since this isn't always possible for taxable accounts, it limits the value of harvesting losses).
The Bottom Line
Many investors don't realize that they can use their brokerage accounts as a tool to help reduce their taxes. And while applying these strategies mid-year can lead to some complexities, it doesn't have to be difficult… and the benefits are worth the effort if you understand how to manage them effectively.
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