Over the past eighteen months, as the equity markets have experienced downside pressure, which had become all too rare in the preceding 12 years or so, the first real opportunities for significant tax-loss harvesting in quite some time have presented themselves to most investors and money managers.
Certainly, we here at Topel & DiStasi Wealth Management have taken advantage of this opportunity on behalf of our clients wherever possible, and while most of you are likely familiar with the concept, we wanted to take this opportunity to explain it for those who aren’t, as well as to discuss some of the merits, and limitations of this fundamental investment-management strategy.
Tax-loss harvesting is a strategy that investors use to minimize their tax liability by selling securities that have experienced a loss and using that loss to offset capital gains. Tax-loss harvesting can be a valuable tool for investors looking to increase their after-tax returns and improve portfolio efficiency. However, investors must be aware of the rules and regulations surrounding tax-loss harvesting, including so-called wash-sale rules.
The primary benefit of tax-loss harvesting, as the name implies, is its ability to reduce taxes. When investors sell securities at a loss, they realize a capital loss, which can be used to offset capital gains realized from the sale of other securities. This can reduce the taxes investors owe on their investment gains and increase their after-tax returns. In addition, if an investor’s capital losses exceed their capital gains in a given year, the excess losses can be used to offset up to $3,000 of ordinary income in that year, and any remaining losses can be carried forward to future years.
For example, suppose an investor has a $50,000 capital gain from the sale of a security and a $20,000 capital loss from the sale of another security. Without-tax loss harvesting, the investor would owe taxes on the full $50,000 gain. However, by using the $20,000 loss to offset the gain, the investor would only owe taxes on the net gain of $30,000. This reduction in taxes can have a significant impact on after-tax returns, especially for high-income investors.
Another benefit of tax-loss harvesting is its ability to maintain a portfolio’s efficiency. By selling securities that have declined in value and reinvesting in similar securities, investors can maintain their desired asset allocation while realizing tax benefits. Rebalancing a portfolio in this way helps an investor maintain their desired risk level and avoid overweighting certain securities or asset classes.
It is vital, however, for investors to be aware of the wash-sale rules when implementing tax-loss harvesting. The wash-sale rule is a regulation that prohibits investors from claiming a loss on the sale of a security if they purchase a “substantially identical” security within 30 days before or after the sale. This means that if an investor sells a security at a loss and buys the same security within the 30-day period, they cannot claim the loss for tax purposes. The loss is added to the cost basis of the new security, and the investor will have to wait until they sell the new security to claim the loss.
For example, suppose an investor sells shares of ABC stock at a loss on December 1st. On December 10th, the investor purchases shares of ABC stock again. Because the purchase was made within 30 days of the sale, the loss cannot be claimed for tax purposes. Instead, the loss is added to the cost basis of the new shares, which will reduce the amount of gain or increase the amount of loss when the new shares are eventually sold.
The way to avoid violating wash-sale rules is by purchasing securities that are not “substantially identical” to the securities that are sold at a loss. For example, an investor could sell shares of a large-cap stock or ETF, and purchase shares of a different large-cap stock or ETF, which would not trigger the wash-sale rule. This has the effect of keeping the original asset mix the same as before the trades, which, in turn, has the effect of keeping the risk and reward characteristics of the portfolio intact.
It is important to note that tax-loss harvesting may not be appropriate for all investors, the most obvious example being those investors who only hold securities in tax-advantaged accounts, such as IRAs or 401(k)s, since gains and losses are not taxed in these accounts.
At the end of the day, tax-loss harvesting is just one of many tools investors can potentially use to increase the effectiveness of their investment portfolios. Under the right conditions, it can be a valuable strategy for investors to minimize their tax liability, and improve portfolio efficiency by offsetting gains with losses, maintaining their desired asset allocation, and maximizing their after-tax returns.
This commentary on this website reflects the personal opinions, viewpoints and analyses of the Topel & DiStasi Wealth Management, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Topel & DiStasi Wealth Management, LLC or performance returns of any Topel & DiStasi Wealth Management, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Topel & DiStasi Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.