What is Tax Loss Harvesting & How to Use It in Your Financial Plan
Finding opportunities to make the most out of difficult markets is key to long-term success. Just because an investment has dropped does not mean you can't make the most of the situation. Tax loss harvesting is a strategy we often use to do just that. When used properly, effective tax loss harvesting can increase the after-tax return you realize in your non-retirement accounts.
Whenever markets are down, tax loss harvesting should be explored. Most of the time, we hear of people or institutions tax loss harvesting in December. At year-end, reviewing tax strategies should be the baseline as an excellent opportunity to offset gains for the year or lock-in tax losses. However, the strategy shouldn't only be reviewed once at the end of the year. Instead, this strategy should be kept in mind year-round, especially in periods of market pullbacks.
What is Tax Loss Harvesting
Tax loss harvesting is a strategy to consider when your investment positions are at a loss, meaning you paid more than the asset is worth today. Sounds the opposite of buying low selling high, right?
Correct!
With proper tax loss harvesting, however, you may be able to sell and replace a position with minimal impact to your overall portfolio composition, while still recognizing all the tax benefits of a "loss." During COVID, we were able to use tax loss harvesting strategies at the right time to create an actual tax loss while markets were down, during a period when markets and our clients' portfolios ended the year with positive double-digit returns. The use of these strategies provided significant tax breaks without drastically changing the composition of the portfolio and allowing for market performance all at the same time.
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Here is an Example of Tax Loss Harvesting:
Let's say you were to buy a fund for $25,000. One year later, the market has dropped and now the holding is only worth $15,000. When you sell this position, you lock in a tax loss on this trade for $10,000 that particular tax year. You may be asking, "Why would I sell at a discount and lock in a loss?" To address this issue, instead of simply selling a position at a low, you may simultaneously buy a similar fund (but it cannot be the exact same holding). Now, your portfolio composition is nearly identical, leaving you with the same portfolio allocation, while still providing the ability to recognize a “loss” for tax purposes.
This loss can offset other gains – short-term losses vs. short-term gains and long-term losses vs. long-term gains. These losses can also simply reduce your total tax bill by reducing your income up to $3,000 (on a joint return). Significant losses can always be carried forward for years to offset future gains as well.
When To Use a Tax Loss Harvesting Strategy
Tax loss harvesting is most effective when you execute these trades while simultaneously purchasing another investment to replace the current holding, or when used with a position you feel no longer fits your investment strategy. One of our clients expected significant tax gains from selling their employee stock options and by utilizing tax loss harvesting, we were able to help offset these expected gains, reduce their overall tax bill, and therefore increase their total after-tax returns for the year. In another example, we had a client who expected a huge tax bill from selling his business. We were able to use a similar tax loss harvesting strategy with his investment account to help him significantly reduce their total tax liability.
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Tax Loss Harvesting Rules to Keep in Mind
Something you may wonder is what rules apply to tax loss harvesting. A key tax loss harvesting red flag to be aware of is what is considered a "wash sale." This applies if you sell a position, only to repurchase the same one, buy options on that position, or if the swapped position is considered substantially identical. If you find yourself in a wash sale situation, the "tax loss" will not be allowed.
As you plan for this strategy, you must know this critical fact about tax loss harvesting: you cannot sell a fund and repurchase the same one within 30 days. If you do, the strategy will be invalid and the tax benefits will be lost. Still, you can find a stock, fund, ETF, etc. that is very similar in nature and utilize this strategy very effectively with little to no impact on your overall portfolio composition and a HUGE benefit to your tax bill.
The benefits of tax loss harvesting do not appear on your statement "returns." However, over time, this strategy can drive actual returns in the sense of a lower tax bill and should be evaluated heavily in your investment strategy. For those with short-term losses in a high tax bracket, you could be saving 35%+ on taxes with efficient tax loss harvesting strategies. If you have any questions about how tax loss harvesting may apply to your financial situation in particular, please do reach out to a member Mainsail advisory team or myself today. We would love to help you incorporate this strategy into your financial planning!