What is Tax-Loss Harvesting?
The COVID-19 Crisis has had the most profound impact on every member of society, perhaps ever. Investors have been forced to decide what financial moves to make, if any. If you have reasoned in your mind that staying invested and taking no action is the best thing to do in this environment, you could be missing out on the benefits of what is known as tax-loss harvesting.
As a warning, I will mention that tax-loss harvesting is a complex strategy that requires a deep understanding of the rules set forth by the IRS. Talk to a professional before implementing this strategy.
What is Tax-Loss Harvesting and What Accounts Are Applicable?
Tax-loss harvesting is a strategy that attempts to lock in the tax benefit of selling the security at a loss, but avoid the investment ramifications of selling a security at a loss.
This strategy only works on taxable accounts, like a joint account, trust account, or individual account (non-IRA, non-Roth IRA). Normally, these accounts are taxed each year on dividends, interest, and capital gains.
Why is Tax-Loss Harvesting Beneficial?
Capital gains (or losses) usually occur at the sale of the security, depending on whether you sold the asset for more or less than what you bought it for. If you sell a security for more than your cost basis, a capital gain occurs. Long-term capital gains are taxed anywhere between 0% – 20%, based on your income. Short-term capital gains are taxed at ordinary income rates. On the flip side, capital losses can either offset capital gains or offset income (up to $3,000/year).
The benefit of harvesting capital losses is the primary appeal of the tax-loss harvesting strategy. Imagine you had $100,000 of capital gains and fell in the 15% capital gains tax bracket. In this scenario, you would owe $15,000 in capital gains tax, assuming the gains are all long-term (meaning you owned the security for at least 12 months).
However, if you took advantage of a tax-loss harvesting strategy and harvested $100,000 of losses, you could use those losses to offset all of your capital gains, resulting in $0 in capital gains tax and a savings of $15,000.
In some cases, you may even be able to harvest more losses than you have gains. If that is the case, you can actually “carry forward” those losses to future calendar years to offset future capital gains. In addition to offsetting capital gains, you can also use capital losses to offset up to $3,000 of ordinary income each year.
Why Tax-Loss Harvest Now?
During this current environment, and in every bear market, it’s common to see “unrealized capital losses” in taxable accounts. An unrealized loss is simply one that hasn’t officially occurred but shows the amount of losses that would occur if the security was sold at that point in time. That is what makes bear markets an opportune time to evaluate whether a tax-loss harvesting strategy could be beneficial.
But while selling a security at a loss is a great thing for your taxes, it may not be the best idea from an investment standpoint. Obviously, selling investments at a loss is not ideal.
What is the Wash Sale Rule?
Tax-loss harvesting attempts to avoid that permanent investment loss by remaining invested throughout this strategy. However, if your first thought is to sell your security today to realize the loss, then buy it back tomorrow, the IRS is one step ahead of you. They have prohibited this “faux sale” strategy through what is known as the wash sale rule. The wash sale rule states that you cannot realize a loss on the sale of security if you buy a substantially identical security within 30 days before or after the sale.
It’s also important to note that the wash sale rule includes IRA and spousal accounts as well. Therefore, selling ABC stock in your trust-owned account and then buying it in your IRA will still constitute a wash sale.
An Example of How Tax-Loss Harvesting Can Work
So, how does this work after all? Imagine you have owned ABC Fund for over 30 days, but you currently recognize that you have an opportunity to harvest losses by selling all shares. At the same time, your primary goal is to remain invested in stocks throughout this crisis. In that instance, you could sell all shares of ABC Fund, and buy XYZ Fund simultaneously. After holding XYZ Fund for at least 30 days, you may then sell XYZ Fund and buy your original ABC Fund again.
By selling ABC Fund and waiting a period of at least 30 days, you would have followed the wash sale rules and would be allowed to keep your realized losses from that original sale.
For some, you may not necessarily care to buy the original security back. If you think the replacement fund might be a better long-term fit, you could consider simply holding that position for the foreseeable future.
Other Risks and Downside
Aside from the previously mentioned risk of a wash sale, there is also the risk of underperformance in your replacement security during the 30-day wash sale waiting period. You could also choose to not purchase a replacement security and simply wait 30 days to purchase your original security back. That also could lead to you missing out on a potential rebound in the original security.
This is where it helps to have help from a qualified investment professional so that they can help you make a prudent decision as you attempt to harvest losses.
As I mentioned, this is a complex strategy, but one that can result in significant tax savings, if done correctly. It is imperative that you seek counsel from a qualified tax and investment professional before implementing this strategy in your accounts. The best place to start is to speak with a CERTIFIED FINANCIAL PLANNER™ professional in your area.
Joe Allaria, CFP®
As featured in The Wall Street Journal, USAToday.com, CNBC.com, Nasdaq.com, and Yahoo Finance.
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