One of the key enemies that investors who buy and sell securities in any type of retail account face is taxes. Large gains translate directly into taxable income that must be reported at the end of the year. In some cases, these gains may put the investor into a higher tax bracket, which can negatively affect other forms of income, such as Social Security or taxable retirement plan distributions.
However, the value of a security can go either up or down after it is purchased, and savvy investors know how to use their losing picks to reduce their tax bills. Harvesting tax losses is a key skill that you can use to keep more of your money in your pocket when you file your taxes for the next year. (For more, see: Pros and Cons of Annual Tax-Loss Harvesting.)
How it Works
Academically speaking, the concept of harvesting tax losses is fairly straightforward. Current tax law divides profits and losses from the sale of securities into four basic categories. There are long term gains and losses for securities that were held for more than one year to the day before they were sold. Short-term gains and losses pertain to profits and losses from the sale of securities that were held for a shorter length of time. In a taxable account, investors may offset an unlimited amount of capital gains with capital losses each year. They must first offset long-term gains against long-term losses and short-term gains against short-term losses. Then they can offset the resultant long-term gain or loss against the net short-term gain or loss to determine a final net long or short-term gain or loss.
Of course, when the final number in this process is a large gain, then the investor is going to owe tax on this income when they file a return. This is where tax loss harvesting can help to reduce the amount owed. For example, consider an investor who sits down just before Halloween and calculates out all of the gains and losses he or she has realized so far during the year. The numbers reveal that he or she has far more gains to report than losses, and will thus create a substantial tax bill next spring.
But this person also bought a block of stock during the summer that is currently only trading at about half of its purchase price. This person may believe that the stock price will begin to climb again at some point, but for now these shares can serve another purpose. The shares are sold for the time being and then are repurchased after at least 31 days have elapsed. A capital loss can now be recognized from this sale which can be used to offset the taxable gain that must be reported. (For related reading, see: Tax-Loss Harvesting: Reduce Investment Losses.)
Beware the Wash Sale Rule
In an effort to stem runaway and irresponsible generation of capital losses for the purpose of harvesting losses, the IRS created a restriction on this practice by dictating that investors must wait at least 31 calendar days before buying back either an identical or like-kind security and then declaring a loss. This creates the risk that the security may rise substantially in price before the required time limit has elapsed, which may make it difficult for the investor to justify repurchasing it. This, of course, can ultimately disrupt a carefully constructed portfolio that was previously fulfilling its desired function in a larger sense.
However, those who are not particularly attached to the exact security that they dumped in order to generate a loss should consider immediately replacing their losing pick with one or more ETFs that cover the larger sector of that security. For example, someone who sells a losing biotech stock could use the proceeds to immediately purchase an ETF that holds similar biotech companies. This approach has two advantages: first, it evades the wash sale issue because it is a fundamentally different security, and it also provides the investor with a measure of diversification.
Enter the Robo-Advisors
Technology has led to the advent of robo-advisors, which are sophisticated computer programs that can perform automated money management services such as tax loss harvesting, portfolio rebalancing and other chores that only humans could previously accomplish. Investors with large accounts who trade frequently can employ these programs to automatically identify and execute tax loss harvesting trades according to specific criteria, such as when a loss that is equal to a certain percentage of the original purchase price occurs.
The program can then check for previous purchases that would trigger the wash sale rule and then sell and repurchase the holding in accordance with IRS regulations. The cost of this service is often minimal and may save the investor a great deal of time and effort—and also substantially improve the overall return generated by the portfolio over time.
The Bottom Line
Although it is not wise for investors to let their tax “tail” wag their investment “dog," a sound tax loss harvesting strategy can reduce the amount of money owed to Uncle Sam each year and also improve the investor’s return on capital in many cases. For more information on how capital gains and losses are computed and what you can to do to minimize your taxable gains, visit the IRS website at www.irs.gov or consult your financial advisor. (For more, see: A Few Good ETFs to Consider for Diversification.)