To Reap the Full Benefits of Tax-Loss Harvesting, Consider This Investment Strategist's Steps
Tax-loss harvesting can offer more advantages for investors than tax relief. Over the long term, it can potentially help you maintain a robust portfolio and build wealth.
As major indexes rebound from recent drawdowns, investors face the challenge of managing portfolios that may look very different than they did at the start of the year.
One strategy to consider is tax-loss harvesting, an approach that not only helps optimize tax efficiency, but can also maintain a balanced portfolio to help weather future market fluctuations.
What is tax-loss harvesting?
Tax-loss harvesting is a financial strategy that involves selling investments that have incurred losses and using those losses to offset the capital gains tax owed on other investments.
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If your losses exceed your gains, you can also potentially offset up to $3,000 of ordinary income each year, with any remaining losses carried forward to future tax years.
This strategy can be particularly useful in times of high volatility or a rotation in market leadership, where investors may see red among certain portfolio investments — offering a way to help reduce tax liability while also realigning investment portfolios towards their long-term strategy.
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Benefits beyond tax season
Investors often think of tax-loss harvesting as a way to reduce their overall tax bill, because realizing losses today can help decrease the amount of capital gains taxes they may owe from investments sold at a gain.
However, this process also provides an excellent opportunity to reassess your overall investment portfolio.
Selling off poorer-performing investments might free up capital that you can reallocate or reinvest in more promising opportunities, potentially leading to a more robust portfolio — all while maintaining similar market exposure.
What's more, the benefits of tax-loss harvesting may also extend beyond immediate tax relief: Over the long term, even a modest improvement in after-tax returns can potentially enhance wealth accumulation.
For instance, in one hypothetical study, we found that a high-net-worth investor aiming to build wealth could see an additional 1.6% return a year by incorporating various tax-efficient strategies in their portfolio, leading to nearly 73% more gains over 20 years.
So, proactively managing your investments and engaging in strategic tax-loss harvesting can play a significant part in building your financial future, even in the face of ongoing market volatility.
How tax-loss harvesting works
There are a few key steps if you're considering getting started with tax-loss harvesting:
Identify underperforming assets. Review your portfolio to identify investments that have lost value throughout the year and consider whether it makes sense to sell them.
Execute trades carefully. When selling assets, be mindful of the IRS's wash-sale rule, which prohibits claiming a tax loss on a security if you repurchase the same or a substantially identical asset within 30 days before or after the sale.
Reinvest wisely. Consider using the proceeds from the sales to buy other investments that fit your asset allocation and investment strategy. This might involve buying similar securities that don't violate the wash-sale rule or choosing different assets that you believe might perform better.
This step is important for staying aligned with your long-term investment goals while still taking advantage of potential tax benefits.
Considerations across different asset classes
While many investors focus on stocks, tax-loss harvesting can also be used with other types of assets, including bonds, mutual funds and certain types of alternative investments — each with varying considerations and complexities.
Remember, it's always important to speak with a tax adviser regarding potential tax implications when considering a strategy such as tax-loss harvesting.
Engaging with financial advisers
A market upswing can be a good time to realign your investment portfolio with your long-term objectives.
Tax-loss harvesting is more than just a tax-season planning strategy; it's a proactive approach to support portfolio management that can provide potential benefits year-round — during market drawdowns, rebounds and periods of higher volatility.
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While the immediate tax benefits of tax-loss harvesting are well known, its long-term impact on wealth accumulation should not be overlooked.
That said, it's important to work with financial professionals, such as a tax adviser and financial adviser, who can offer guidance tailored to your specific financial situation and help you manage the timing and selection of asset sales and purchases.
They can also help you remain compliant with tax laws while enhancing your portfolio for tax efficiency and staying on target for your overall investment objectives.
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