Many investors undertake tax-loss harvesting at the end of every tax year. The strategy involves selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments carrying a loss to offset realized gains from other investments. It can have a big tax benefit.
But tax-loss harvesting may or may not be the best strategy for all investors for several reasons.
Newest Tax Rates
The Internal Revenue Service (IRS), many states, and some cities assess taxes on individuals and businesses. At times, the tax rate—the percentage for the calculation of taxes due—changes. Knowing the latest rates regarding investments helps you decide if tax-loss harvesting is smart for you now.
- Keeping up with the latest rates regarding investments is necessary to decide whether or not tax-loss harvesting is a smart choice.
- Tax-loss harvesting, when done in the context of rebalancing your portfolio, is a best scenario.
- One consideration in a given year is the nature of your gains and losses.
For the 2020 tax year, federal tax rates on items potentially pertinent to harvesting include: the top rate for long-term capital gains, 20%; the Medicare surtax for high-income investors, 3.8%; and the highest marginal rate for ordinary income, 37%.
Though all investors may deduct a portion of investment losses, these rates make investment losses potentially more valuable to high-income investors.
Understand the Wash-Sale Rule
The IRS follows the wash-sale rule, which states that if you sell an investment to recognize and deduct that loss for tax purposes, you cannot buy back that same asset—or another investment asset “substantially identical”—for 30 days.
In the case of an individual stock and some other holdings, this rule is clear. If you had a loss in Exxon Mobil Corp., for instance, and wanted to realize that loss, you would have to wait 30 days before buying back the stock. (This rule can actually extend to as much as 61 days: You would need to wait at least 30 days from the initial purchase date to sell and realize the loss, and then you need to wait at least 31 days before repurchasing that identical asset.)
Let's look at a mutual fund. If you realized a loss in the Vanguard 500 Index Fund, you couldn’t immediately buy the SPDR S&P 500 ETF, which invests in the identical index. You likely could buy the Vanguard Total Stock Market Index, which tracks a different index.
Many investors use index funds and ETFs, as well as sector funds, to replace stocks sold and not violate the wash-sale rule. This method may work but can also backfire for any number of reasons: extreme short-term gains in the substitute security purchased, for example, or if the stock or fund sold appreciates greatly before you have a chance to buy it back.
Further, you cannot avoid the wash-sale rule by buying back the sold asset in another account you hold, such as an individual retirement account (IRA).
One of the best scenarios for tax-loss harvesting is if you can do it in the context of rebalancing your portfolio. Rebalancing helps realign your asset allocation for a balance of return and risk. As you rebalance, look at which holdings to buy and sell, and pay attention to the cost basis (the adjusted, original purchase value). Cost basis will determine the capital gains or losses on each asset.
This approach will prevent you from selling only to realize a tax loss that may or may not fit your investment strategy.
A Bigger Tax Bill Down the Road?
Some contend that consistent tax-loss harvesting with the intent to repurchase the sold asset after the wash-sale waiting period will ultimately drive your overall cost basis lower and result in a larger capital gain to be paid in the future. This could well be true if the investment grows over time and your capital gain gets larger—or if you guess wrong regarding what will happen with future capital gains tax rates.
Yet the current tax savings might be enough to offset higher capital gains later. Consider the concept of present value, which says that a dollar of tax savings today is worth more than additional tax you must pay later.
This depends on many factors, including inflation and future tax rates.
Capital Gains Are Not Created Equal
Short-term capital gains are realized from investments that you hold for a year or less. Gains from these short holdings are taxed at your marginal tax rate for ordinary income. The Tax Cuts and Jobs Act sets seven rate brackets for 2020, from 10% to 37% depending on income and how you file.
Long-term capital gains are profits from investments you hold for more than a year, and they're subject to a significantly lower tax rate. For many investors, the rate on these gains is around 15% (the lowest rate is zero and the highest, 20%, with few exceptions). For the highest income brackets, the additional 3.8% Medicare surtax comes into play.
You should first offset losses for a given type of holding against the first gains of the same type (for example, long-term gains against long-term losses). If there are not enough long-term gains to offset all of the long-term losses, the balance of long-term losses can go toward offsetting short-term gains, and vice versa.
Maybe you had a terrible year and still have losses that did not offset gains. Leftover investment losses up to $3,000 can be deducted against other income in a given tax year with the rest being carried over to subsequent years.
Tax-loss harvesting may or may not be the best strategy for all investors for several reasons.
Certainly, one consideration in the tax-loss harvesting decision in a given year is the nature of your gains and losses. You will want to analyze this or talk to your tax accountant.
Mutual Fund Distributions
With the stock market gains over the past few years, many mutual funds have been throwing off sizable distributions, some of which are in the form of both long- and short-term capital gains. These distributions also should factor into your equations on tax-loss harvesting.
The Bottom Line
It's generally a poor decision to sell an investment, even one with a loss, solely for tax reasons. Nevertheless, tax-loss harvesting can be a useful part of your overall financial planning and investment strategy, and should be one tactic toward achieving your financial goals. If you have questions, consult a financial advisor or tax professional.