May 10, 2022 – By Frank Corrado, CPA, CFP®, RLP.
The recent sell-off in the capital markets has left investors with unrealized capital losses in their portfolios. While no one goes into an investment to lose money, part of having a well-diversified portfolio is embracing the reality that while some stocks perform well, some do not.
Luckily, you don’t have to be a loser because some of your stocks are. Tax-loss harvesting is an investing strategy that can turn a portion of your investment losses into tax offsets, helping turn financial losses into wins.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is when you sell some investments at a loss to offset gains you’ve realized by selling other stocks at a profit. You only pay taxes on your net profit or the amount you’ve gained minus the amount you lost, thereby reducing your tax bill.
Investors can use the proceeds from selling their floundering assets to fund purchases of similar investments that may grow over time and help recoup their losses. These future gains can then be offset by future losses, perpetuating a virtuous cycle of tax savings.
A quick reminder: When you sell an investment asset for a profit, you owe capital gains on the profits based on how long you held the asset. If you have owned it for less than one year, you’ll pay your ordinary income tax rate on any gains. If you kept it for more than one year, you’ll owe the preferential long-term capital gains rate, which could be as low as 0%, but won’t exceed 20%, even for top earners.
If you hope to harvest losses and enjoy the benefits they offer, you must complete sales transactions before the end of the tax year. For example, if you want to harvest losses from 2022, the transactions would have had to be completed by December 31, 2022.
Tax-Loss Harvesting and Ordinary Income
While we use investment losses to reduce capital gains taxes, even those who do not report capital gains can benefit from tax-loss harvesting. That’s because you can offset ordinary income with your investment losses.
Single filers, and married couples filing jointly, can deduct up to $3,000 in realized losses from ordinary income. Married couples filing separately can each deduct $1,500 from regular income. If you have more than $3,000 in realized losses, the excess losses can be carried over into future tax years in $3,000 increments.
Additional Considerations for Tax-Loss Harvesting
Wash Sales
Besides reducing your taxes, tax-loss harvesting also frees up cash so you can buy new assets that may be more likely to generate positive performance. You’ll probably want to buy a similar type of investment to keep your asset allocation and risk profile unchanged.
There are rules to keep in mind while navigating your next purchase. You can’t, for instance, sell stock to realize a loss and minimize your tax burden and then rebuy that exact same stock or a nearly identical one.
This maneuver is referred to as a “wash sale.” A “wash sale” occurs when you sell securities at a loss and within 30 days before or after the sale buy “substantially” identical securities or acquire a contract or option to do so.
However, the wash sale rule does not preclude purchasing securities in the same industry. For example, you can sell Exxon shares and replace them with shares of Shell. That said, things can get a little more complex regarding mutual funds and exchange-traded funds (ETFs). You can’t, for instance, sell one company’s index fund and then buy another company’s tracking the same index, or even one that contains most of the same companies.
Cost-Basis Calculations
To calculate capital gains and losses (and, therefore, how much you can harvest), you need to know the cost basis, or what you originally paid for a security. If you bought all your shares at once, this should be easy to find and calculate gains.
But chances are you accrued your shares over time, using a strategy like dollar-cost averaging. While dollar-cost averaging can help lower the amount you pay for investments on average, it can also create record-keeping challenges.
You’ll need to know the date and value at which you purchased each share to calculate how much it’s grown and whether it’s eligible for long- or short-term capital gains taxes. Luckily, your brokerage account should, at the very least, have a record of your original purchase date and price that you can then use to determine your actual gains.
Should You Use Tax-Loss Harvesting with Your Investments?
Tax-loss harvesting can be a very effective strategy for investors who hold securities in taxable accounts (i.e., not your retirement accounts).
Researchers at MIT and Chapman University calculated that tax-loss harvesting yielded almost an additional 1% annual return each year from 1928 to 2018.
While investors can benefit from harvesting losses at any time, down markets (like the one we are in at the current time) may offer even more excellent opportunities to realize losses and use sale proceeds to purchase other securities at bargain prices. In addition to offsetting losses against gains, new investments may enhance portfolio performance as the market recovers.
We never let the “tax tail wag the dog,” so harvesting losses is most appropriate and beneficial when it generates tax savings without disrupting or abandoning the primary investment strategy.
Tax-loss harvesting yields the most significant benefits for investors in higher tax brackets. The higher your income tax bracket, the more money you can save by minimizing your taxable gains. Moreover, investors in higher tax brackets are also likely to have more invested assets and more opportunities for offsetting transactions.
By contrast, in 2022, those earning less than $40,675 as single filers, or $83,350 as joint filers, won’t owe anything on their long-term capital gains, making tax-loss harvesting a moot point. For investors who make more than those cutoffs but who aren’t huge traders, it’s important to weigh factors such as transaction costs and complexity against the potential benefits.
No matter what tax bracket you find yourself in, harvesting losses can create additional operational burdens. We provide this service to our clients so they can fully realize the benefits of tax-loss harvesting with minimal headaches.