Annual tax-loss harvesting is a process undertaken by many investors at the end of every tax year. Tax-harvesting helps with reducing tax burdens. The strategy involves selling stocks, mutual funds, exchange traded funds (ETFs), and other investments carrying a loss to offset the realized gains from other investments.
Tax-harvesting may or may not be the best strategy for all investors for several reasons.
More Than Just Tax Considerations
Often, it is generally a poor decision to sell an investment, even one with a loss, solely for tax reasons. However, tax-loss harvesting can be a useful part of your overall financial planning and investment strategy as long as it doesn’t lead to decisions that are ultimately in conflict with that strategy. (For more, see: When to Dump Portfolio Losers.)
Increased Tax Rates
The Internal Revenue Service (IRS), many states, and even some cities will assess taxes on individuals and businesses. At times, the tax rate—the percentage for the calculation of taxes due—will change to help fund the operations of these government entities.
For 2018, the IRS increased tax rates they will use to evaluate several items, these include:
- The top rate for long-term capital gains increased to 20% from 15%.
- A new 3.8% Medicare surtax for high-income investors raised the highest effective capital gains tax rate to 23.8% for these taxpayers.
- The highest marginal rate for ordinary income has increased to 39.6% from 35%.
These increases potentially make investment losses more valuable to higher income investors. However, all investors may deduct a portion of investment losses if the choose.
Understand the Wash Sale Rule
The IRS follows the wash sale rule. This regulation states that if you sell an investment holding to recognize and deduct that loss for tax purposes you cannot buy back that same asset—or another investment asset that is “substantially identical” to it—for 30 days following the sale. (For more, see: Tax-Loss Harvesting: Reduce Investment Losses.)
In the case of an individual stock, this rule is pretty clear. If you had a loss in Exxon Mobil Corp. (XOM) and wanted to realize that loss you would have to wait 30 days before buying back into the stock if you want to own it again. This rule can actually extend to be 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.
In the case of a mutual fund, if you realized a loss in the Vanguard 500 Index Fund (VFINX), you couldn’t buy the SPDR S&P 500 ETF (SPY), which invests in the identical index. You likely could buy the Vanguard Total Stock Market Index (VTSMX), though, as this fund tracks a different index.
Many investors use index funds and ETFs, as well as sector funds, to replace stocks sold to not violate the wash sale rule. This method may work but can backfire for any number of reasons. Some of the ways this can backfire are with extreme short-term gains in the substitute security purchased or if the stock or fund sold goes 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 using an individual retirement account (IRA). (For more, see: Taking the Sting out of Investment Losses.)
One of the best scenarios for tax-loss harvesting is if it can be done in the context of the normal rebalancing of your portfolio. Rebalancing helps to realign your asset allocation in your holdings. 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 won’t cause you to sell solely to realize a tax loss that may or may not fit your investment strategy. (For more, see: Rebalance Your Portfolio to Stay on Track.)
A Bigger Tax Bill Down the Road?
Some financial advisers contend that consistent tax-loss harvesting with the intent to repurchase the sold asset after the waiting period dictated by the wash sale rule will ultimately drive your overall cost basis lower and result in a larger capital gain to be paid at some point in the future. This could well be true on two counts.
- If the investment grows over time your capital gain can get larger.
- You don’t know what will happen with future capital gains tax rates.
However, the flip side of this is that the current tax savings might be enough to offset higher capital gains taxes later. Consider the concept of present value (PV), which says that a dollar of tax savings today is worth more than any additional tax to be paid later on. Clearly, this will depend on a variety of factors including inflation and future tax rates.
Capital Gains Are Not Created Equal
Short-term capital gains are those realized from investments that you held for a year or less. Gains from these short holdings are taxed at your marginal tax rate for ordinary income. The 2018 Tax Cuts and Jobs Act (TCJA) sets seven rate brackets for 2019, ranging between 10% and 37%, depending on how you file. (For related reading, see: Capital Gains 101.)
Long-term capital gains are those profits realized from investments held for over a year and receive a significantly lower tax rate. For many investors the rate on these gains is around 15%—the lowest rate is zero and the highest rate is 20%. Also, remember that for the highest income brackets, the additional 3.8% Medicare surtax comes into play here as well. (For related reading, see: Capital Losses and Tax.)
Losses of a given type should first be offset 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 then 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. Left-over 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.
Certainly, one of the considerations 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 before moving forward.
Mutual Fund Distributions
With the stock market gains of the 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 the equation.
Look at the Big Picture
Tax-loss harvesting is but one tactic that can be used on the path toward achieving your financial goals. In order to determine if this is a good idea for you step back and first look at your overall tax situation.
The Bottom Line
While it is a good idea to review your portfolio for tax-loss harvesting opportunities at least annually, whether or not to move forward should be evaluated in the overall context of your tax situation and whether or not these transactions fit with your overall investing strategy. Tax reduction is a strategy and not an end unto itself. Make sure to consult with a financial advisor or tax professional knowledgeable in this area. (For more, see: 7 Year-End Tax Planning Strategies.)