In some alternate universe, there may be markets where nobody ever experiences any loss and every investment just keeps growing, 24×7. In our world, we know better. While markets are expected to climb over time, periodic downturns happen. When they do, they can leave you feeling left out in the cold. Our advice? Look for opportunities to leverage inclement markets through year-round, tax-loss harvesting.
Tax-Loss Harvesting: An Overview
The concept of tax-loss harvesting is relatively simple. We’ll go into more detail in a moment, but the general goal is two-fold:
1. Realize a loss for tax purposes. When appropriate, sell assets at a loss and use the losses to offset taxable gains on other investments.
2. Keep those assets in the market according to your investment plan. Buy a similar holding (that is not “substantially identical”), until you can reinvest as originally intended without running afoul of the IRS’ “wash sale rule.”
In other words, tax-loss harvesting is not about abandoning your carefully crafted asset allocations by panic-selling a losing holding. It’s about achieving an available tax-break, while sticking to your disciplined investment strategy throughout.
What Is the Wash Sale Rule?
There are several mutual funds and ETFs that make good substitutes for one another from a practical perspective. But when tax-loss harvesting, you cannot claim a deductible loss on a sale if you (or your spouse, for joint filers) sell a security at a loss and buy the same security or a “substantially identical” one within 30 calendar days before or after the sale. If you violate either of these conditions, the IRS’ wash sale rule will typically disallow the loss for current income tax purposes. Thus it’s important to use caution in choosing “similar” funds.
A Tax-Loss Harvesting Illustration
It might help to see an illustration. Assume you purchase a fund for $10,000. Two months later, it’s trading at $7,000. You decide to harvest the short-term $3,000 loss (short-term, since the fund was held less than a year). With a 35 percent ordinary federal income tax, this can result in a $1,050 tax savings.
At the same time, you take the $7,000 from the sale and reinvest it in a similar holding. After 31 days, you can reinvest it back where it came from. As long as the market eventually recovers, you’ve effectively lost nothing, while gaining a $1,050 tax break.
There Is No “Tax-Loss Harvesting Season”
Maybe it’s because tax-loss harvesting is associated with tax-planning, but many investors (and even some advisors) treat it as strictly a year-end task.
This is a mistake. Losses can occur any time of year, and vanish by year-end. On the one hand that’s good, because it means your investments are no worse for the wear (if you remained invested). But if you skip the opportunity to also tax-loss harvest when the (hopefully) temporary losses occur, you skip the chance to lower your tax bill while you’re at it.
How It Works (and How It Doesn’t)
Now that you understand the basics, let’s cover some of the finer points. In his December 2015 MarketWatch article, “It’s a good time to harvest losses,” Robert Powell shares BAM ALLIANCE Director of Investment Analysis Kevin Grogan’s advice: “Most investors should do tax-loss harvesting as long as the loss is large enough.”
But what is “large enough”? As we’ll explain in a moment, tax-loss harvesting opportunities are best considered on a case-by-case basis, but in the aforementioned article, Grogan offers some starting points: For stocks, start with at least a $5,000 or 5% loss, and for bonds at least a $5,000 or 2% loss.
There are additional factors to help you decide when a loss seems ripe for harvesting.
Clearly, it won’t make sense to harvest a tax loss if the trading costs are going to erase the benefits. For example, say your tax break would be $100. You’re best off staying put if it’s going to cost you $80 to complete the trades involved (selling the initial holding, reinvesting in a similar one, and ultimately repurchasing the initial one).
You cannot harvest losses from holdings that are in your tax-sheltered accounts (such as IRAs or retirement plans). Since realized gains in these accounts are not taxable to begin with, they cannot be offset with any losses.
There can be times when the market is so extraordinarily volatile that you are best off remaining seated. Remember, your goal for tax-loss harvesting is to sell at a loss, AND invest in a temporary replacement holding that is similar (but not “substantially identical”). You then typically want to swap back to your original holding after 31 days. This ensures your portfolio remains true to your greater wealth plans.
When you go to complete a swap, it works best when the price of your replacement holding is the same or lower than the price you paid for it. Why is that so? Taxes. When you sell the replacement holding, if it’s gone up in value, you’ll incur short-term taxable gains, which could cost you more than the losses will save you.
Because highly volatile assets often incur large gains or losses over very short periods, tax-loss harvesting should be carefully executed when the market is highly unstable. For example, as part of what we do for our clients, we used tax-loss harvesting where appropriate following the passage of the June 23, 2016 Brexit referendum. Depending on your individual holdings and your ability to focus on careful execution, it might or might not have made sense for you to do the same.
Why Are Short-Term Losses More Valuable?
In our earlier illustration, we mentioned harvesting a short-term loss. Why would it matter? Again: taxes. Short-term losses are first deducted against short-term gains that are otherwise taxed at higher ordinary income tax rates. Long-term losses are first deducted against long-term gains that are otherwise taxed at lower capital gains rates. Thus, short-term losses are considered more valuable to your tax management efforts, especially if you are in a higher tax bracket.
Given that periodic market losses are inevitable and inherent to investing, we would be remiss if we didn’t do all that we could to help our clients make the most of them when they occur. We seek to fulfill that role by employing year-round tax-loss harvesting as part of our wealth strategy – while also ensuring that the tax-loss harvesting “tail” doesn’t inappropriately wag the portfolio management “dog.”
Do you still have questions about your own tax-loss harvesting strategy? Let us know.