At the time of this writing, most areas of the global stock and bond markets are down for the year. Recent weeks have also been volatile. You may wonder if you should take some action. Perhaps, but if these times are emotional for you, inaction is often the wisest course.

Market downturns provide an opportunity to consider if tax loss harvesting makes sense. If you’re unfamiliar with the term, you might guess it is related to tax planning. It’s a process I regularly evaluate for clients. So why is it important? In this blog, we’ll explore by answering three questions:

• What is tax loss harvesting?
• Who does tax loss harvesting benefit and who does it hurt?
• What are the key risks and considerations for implementing it?

What is Tax Loss Harvesting?

Tax loss harvesting sounds strange. When you think about harvesting, you might envision farming and crops being gathered. Crops represent some positive yield, and you’re reaping the benefits.

In the financial world, can you really harvest a loss? If you look closely, you may find opportunities. Tax loss harvesting is the act of selling investments at a loss to harvest the tax savings. How does it work?

First, understand that it only applies to after-tax or non-qualified accounts. Retirement accounts like 401ks and IRAs do not benefit from this. Put another way, tax loss harvesting is a strategy to improve your after-tax investment returns.

Generally, a loss happens when you sell an investment for less than what you paid for it. A gain happens when you sell for more than what you paid. This is an oversimplification. The broader point is if you have investment gains, you may have to pay taxes. As such, you may seek ways to lower those taxes in a sensible way, while playing within the IRS rules.

Maximum Annual Benefit for Tax Loss Harvesting

When managing your portfolio, you may need to sell multiple investments during the year. Some positions may be at a gain. Others may be at a loss. The cool thing is you can manage your overall tax exposure by using losses to offset gains.

Furthermore, if your overall losses exceed your gains in a year, you end up with a net capital loss. The tax law allows you to use $3,000 of such losses and deduct it against other non-investment income sources such as wages.

If you have more than $3,000 in net capital losses for the year ($1,500 if married filing separately), you get no more immediate benefit. But you can carry forward your excess loss to the next year. In theory, you can carry forward a very large capital loss for many years and use it to offset your future capital gains.

This almost sounds like you want to have losses. Not quite. You do want your investments to rise in value, but there’s no guarantee. You might have an investment with good long-term potential, but the ride can be bumpy in the short term. Tax loss harvesting is less about seeking losses and more about adapting when they inevitably happen.

Who does Tax Loss Harvesting Benefit and Hurt?

Know Your Exposure

There are three main tax rates for capital gains: 0%, 15% and 20%. For simplicity, I’m assuming federal taxes only (not state) and that your net capital gains get what’s called long-term tax treatment. To understand your specific exposure, consider consulting a financial planner or tax expert. Disclaimers aside, let’s look at a few rules of thumb.

If you’re in the highest 20% rate, it will often make sense for you to take advantage of tax loss harvesting when you can. In 2022, you’re in this group if your taxable income is greater than $517,200 (Married) or $459,750 (Single). Because there’s an additional 3.8% net investment income tax, your actual tax rate on capital gains is 23.8%.

For those of you in the 15% rate, tax loss harvesting could help or hurt, but it will be situation dependent. In 2022, you’re in this group if your taxable income is between $83,500 and $517,200 (Married) or between $41,675 and $459,750 (Single). If you’re in this group, you could also be exposed to the additional 3.8% tax mentioned above.

If you’re in the lowest 0% rate, tax loss harvesting usually does not make sense. You would want to do tax gain harvesting instead. Why? Because you can capture those gains with no federal income tax consequences! In 2022, you’re in this group if your taxable income is less than $83,450 (Married) or $41,675 (Single).

Tip: Gain harvesting is also a strategy you might consider if you’re trying to build tax-free assets.

Tax Avoidance vs Tax Deferral

At this point, it’s worth clarifying that tax loss harvesting is not tax avoidance. It is tax deferral. When you take a loss, you’re effectively deferring the capital gains tax to the future by lower your tax basis today. An example may help.

• Let’s say you bought a stock for $10,000. Your tax basis in the stock is simply what you paid for it, $10,000. Six months later, the stock goes down in value to $7,000 and you decide to sell. Assume no dividends were reinvested. You harvest a $3,000 capital loss ($7,000 market value less $10,000 basis). This action may help you reduce taxes this year.
• Now assume you reinvest that $7,000 (mindful of the rules discussed in the next section), your tax basis in the new stock is $7,000. Assume the stock subsequently goes back up to $10,000 over the next one year. If you sell at that point, you harvest a $3,000 capital gain ($10,000 market value less $7,000 basis). This gain may be subject to taxes (e.g., one of the 3 rates noted in the last section).

For planning purposes, you could have times where you expect to be in a different tax bracket soon. In those cases, it’s easier to determine if tax loss or tax gain harvesting is the route to go.

For example, if you know you are leaving a job to take some time off or even retire, you could reasonably expect to be in a lower capital gains tax bracket soon. All else equal, that means taking losses now (at a higher tax bracket) is more valuable than waiting to a future time (at a lower tax bracket).

Key Risks and Considerations for Implementing Tax Loss Harvesting

Wash Sale Rules

One of the key rules to know is the IRS wash sale rules. Another funny term. This simplest definition is if you sell an investment to harvest a loss, you cannot purchase that same investment back immediately. You could risk losing the tax deduction and face a higher-than-expected tax bill if you don’t follow the rules.

Instead, you must wait 30 days to repurchase that investment. For thoroughness, you shouldn’t purchase a “substantially identical” investment to the one from which you harvested losses in the previous 30 days or subsequent 30 days of the sale date.

After a loss sale, the risk is the investment you just sold may rise in value during that waiting period. Alternatively, you can purchase a different investment immediately if that makes sense within your overall plan. If such an investment doesn’t fit well into your longer-term plans, you can switch back to your original investment after 30 days. That switch itself may have tax and transaction costs implications.

With individual stocks, for example, it’s easy to know if you’re in violation of the wash sale rules. With diversified investments like mutual funds and exchange traded funds, it gets trickier to know if your replacement investment violates the wash sale rules. The rules and enforcement from the IRS are not clear. It’s beyond the scope of this blog to cover all the nuances. If interested in the details, this advisor-focused piece from Kitces.com does a nice job summarizing those areas.

A tip for Mutual Funds Owners: If you sell a portion of a mutual fund at a loss, you might inadvertently be exposed to a wash sale violation. Mutual funds often have automatic dividend reinvestment. So, if your fund pays out a dividend during the wash sale period, it results in an automatic purchase of shares. The impact here will vary. But you can avoid the issue altogether by disabling dividend reinvestment or other types of automatic purchases.

Final (Random) Considerations

• The value of tax loss harvesting is not the same for everyone. Consider tax loss harvesting in the context of your overall tax planning. It may compliment or detract from other goals you have.
• Reinvest tax savings generated from tax loss harvesting. If tax loss harvesting is to truly provide you with a higher after-tax investment return, be conscious of what you’re doing with the tax savings. Reinvest it if possible. Admittedly, this takes some discipline to execute regularly.
• Tax loss harvesting should be more of a system than a goal. I wrote about the difference in an earlier blog here. This is one system I’m continually trying to improve and refine for my clients.
• A factor in favor of tax loss harvesting: you plan on donating your investments to charity. That is because a decreased basis (that comes from loss harvesting) doesn’t impact your tax situation if you donate that investment. Some additional consideration is needed if you plan to gift the investment to an individual (not a charity).
• A factor against tax loss harvesting: you don’t think you can use up carryover losses during your lifetime. Without getting into all the nuances, capital losses not used up in the year of death could be permanently lost.

I hope you found this a helpful primer on tax loss harvesting. If you have comments or questions on this piece, please drop me a line at: [email protected]

References

1. https://www.irs.gov/taxtopics/tc409
2. https://krishnawealth.com/how-80-percent-of-our-retirement-assets-became-tax-free/
3. https://www.kitces.com/blog/tax-loss-harvesting-best-practice-scaling-execution-challenges-wash-sale-rules/
4. https://krishnawealth.com/have-goals-but-focus-on-systems/

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