When markets turn volatile, taking losses to offset capital gains can prove to be a relatively low risk way to improve your investment portfolio’s outcome. We’re talking about tax loss harvesting and another way we are committed to Increasing your Value of Time®.
The Basics of Tax-Loss Harvesting
This strategy is typically done at the end of the year, but it can be done at any time it’s advantageous to do so. It involves selling an investment at a loss and reinvesting the proceeds into a similar investment, or “proxy”. The benefit of realizing the loss is a reduction of your tax burden, either by offsetting your taxable income or capital gains. Realized losses can offset up to $3,000 of ordinary income and unused losses can be carried forward indefinitely.
By reinvesting the proceeds into a similar investment called a proxy, the portfolio’s overall asset allocation, risk and return parameters are maintained. After a period of 30 days, the trades are reversed to our preferred investment. This is required to avoid violation of the IRS’s “wash sale” rule.
Tax-loss harvesting involves certain risks, including the risk that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. There are also restrictions on using specific types of losses to offset certain gains. A long-term loss would first be applied to a long-term gain, and a short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type. Furthermore, tax-loss harvesting isn't useful in retirement accounts, such as a 401(k) or an IRA, because you can't deduct the losses generated in a tax-deferred account.
An Example of Tax-Loss Harvesting
Let's say you recognize a gain of $20,000 on a stock you bought less than a year ago (Investment A). Because you held the stock for less than a year, the gain is treated as a short-term capital gain and will be taxed at the higher ordinary-income rates rather than the lower long-term capital-gain rates, which apply to investments held for more than a year.
At the same time, you also sell shares of another stock for a short-term capital loss of $25,000 (Investment B). Your $25,000 loss would offset the full $20,000 gain from Investment A, meaning you'd owe no taxes on the gain, and you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years. Assuming you're subject to a 35% marginal tax rate, the overall tax benefit of harvesting those losses could be as much as $8,050.
By offsetting the capital gains of Investment A with your capital loss of Investment B, you could potentially save $7,000 on taxes ($20,000 × 35%). Because you lost $5,000 more than you gained ($25,000 – $20,000), you can reduce your ordinary income by $3,000, potentially lowering your tax liability an additional $1,050 ($3,000 × 35%) for a total savings of $8,050 ($7,000 + $1,050). You could then apply the remaining $2,000 of your capital loss from Investment B ($5,000 – $3,000) to gains or income the following tax year.
Source: (1) https://www.schwab.com/learn/story/how-to-cut-your-tax-bill-with-tax-loss-harvesting
(2) https://www.fidelity.com/viewpoints/personal-finance/tax-loss-harvesting
Views expressed are as of the date indicated and are not intended to serve as investment advice, tax advice, a recommendation, offer, or solicitation to buy or sell any securities; they are based on the information available at the time and are subject to change based on economic, capital market, and other conditions. Any investment decision should be based on an individual’s own goals, time horizon, and tolerance for risk.
Prior performance does not guarantee future results and there is the potential for the loss of your capital investment.
Information and data provided have been obtained from sources deemed reliable but are not guaranteed.
