Tax-loss harvesting can be useful in an array of situations, but understanding when to best utilize this strategy is key. Tax-loss harvesting is the practice of selling an investment for a loss. By realizing, or harvesting, a loss, investors can offset taxes on gains and income.
The following example illustrates the concept:
On the first day of the year, you invest $50,000 in a fund that tracks the entire U.S. stock market. The market drops approximately 20% by May 1, and as a result the value of the fund has dropped to $40,000. While few people enjoy watching the market fall, there is one potential benefit: You can sell the investment, realizing a $10,000 loss for tax purposes.
At this point, you can then purchase a different fund that tracks only the S&P 500. Per IRS rules, you must wait at least 30 days from the day the loss was realized before purchasing a “substantially identical” investment, but by choosing this method you can immediately purchase a fund that tracks a different index. After 30 days elapse, you may then switch back to the original investment, or continue to hold the new investment if it meets your needs.
Continuing with this scenario, by Sept. 1 the market rallies and the S&P 500 fund you purchased is now sitting at $55,000. You are satisfied with holding the S&P 500 fund for the long term, therefore you have locked in a loss for tax purposes while the value of your investments has increased.
Tax-loss harvesting has the potential to add value in a number of circumstances, but it does not make sense for every situation. Tax-loss harvesting both creates a capital loss for tax purposes in the current year and also lowers the cost basis of the investments you own.
Taking long-term advantage of this tax tool
One of the most powerful benefits of tax-loss harvesting stems from the fact that after offsetting other capital gains, the first $3,000 ($1,500 if married filing separately) you accumulate in capital losses offsets ordinary income each year. Any remaining losses can be carried forward to future years. Since tax rates for ordinary income tend to be higher than long-term capital gains rates, your tax savings on the first $3,000 each year is equal to the difference between tax rates for long-term gains and ordinary income, multiplied by $3,000.
Another situation where tax-loss harvesting is likely to make sense is when you have substantial assets in taxable brokerage accounts that you are investing for future generations, and do not anticipate spending down these assets in the near future. Assets receive a step-up in basis at death, which means that the lower basis that is created from tax-loss harvesting does not create any negative impact.
When tax-loss harvesting may not be a good idea
Conversely, a situation where it might be best to avoid tax-loss harvesting is if your long-term capital gains rate is 0%. In this scenario, it actually might be best to “tax-gain harvest,” which means selling investments with long-term capital gains and immediately repurchasing the same investment. There is no 30-day waiting period to repurchase a similar investment when realizing gains.
For example, a retired couple owns a mutual fund with $10,000 in unrealized long-term gains. This couple is currently in the 15% tax bracket for ordinary income and the 0% bracket for long-term capital gains. They have significant assets in IRA accounts and will begin taking required minimum distributions (RMDs) next year. These RMDs will push their income into the 25% bracket for ordinary income and the 15% bracket for long-term capital gains. They take advantage of the lower rates this year by selling this fund now and immediately repurchasing the same fund at the same price. Their cost basis in the mutual fund will increase by $10,000 with no tax burden for federal tax purposes.
Realizing this gain in the 0% long-term capital gains bracket provides a tax savings of $1,500 over selling the fund when their capital gains tax rate increases to 15%.
It is also important to consider state tax rules when considering tax-loss harvesting. For example, New Jersey and Pennsylvania do not allow you to carry losses forward to future years. Alabama does not allow losses to be carried forward, but does allow you to fully offset ordinary income in the year the loss occurs.
Your current and future tax rates matter
Finally, a circumstance where tax-loss harvesting is likely to add value, but needs to be carefully analyzed, is when you have relatively high current income and expect lower income when spending down taxable assets in retirement. In this case, you need careful planning. If you anticipate that your capital gains tax bracket in retirement will be the same or lower than it is currently, tax-loss harvesting should work to your benefit.
Beyond the $3,000 per year in tax losses that offset ordinary income, it is important to remember that your current and future capital gains tax rates matter. Since tax-loss harvesting lowers the cost basis, investors who are currently in the 15% long-term capital gains tax bracket need to analyze the risk of future realized gains pushing them into a higher tax bracket.
For investors who anticipate that they will be in the same tax bracket in the future as they are now, the gain beyond the first $3,000 each year is derived from time value of money (the concept that a dollar is worth more today than in the future because of its potential to grow). The best way to maximize the time value of tax-loss harvesting is to invest any tax savings into the market so these savings are likely to compound at a much higher rate over time.
Tax-loss harvesting can be beneficial for some investors, providing the opportunity to create value based on the structure of tax laws. This may help to slightly ease one’s pain during the next market downturn.
Kevin Peacock is the managing member of Astra Capital Management, a fee-only investment advisory firm based in New York City. Astra Capital Management utilizes an evidenced-based approach to investment management and financial planning customized for each client's unique wealth objectives. Kevin is a CFP® professional and holds the CAIA® designation. His educational background includes a master's degree in Financial Engineering and an MBA with a finance concentration.
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