Investing is often associated with the pursuit of gains, but there’s a lesser-known strategy that involves embracing losses to achieve financial benefits: tax-loss harvesting. This technique, primarily used in taxable investment accounts, can reduce an investor’s tax liability by strategically selling investments that have decreased in value. The concept might seem counterintuitive at first, but when executed correctly, it can lead to significant tax savings. Let’s dive into what tax-loss harvesting is, why investors use it, and how it can benefit you with a real-world example.
What is Tax-Loss Harvesting?
Tax-loss harvesting is the practice of selling an investment that has experienced a loss to offset the capital gains tax liability on other investments. Capital gains taxes are levied on the profit made when an investment is sold for more than its purchase price. By selling an underperforming investment at a loss, an investor can use that loss to offset any gains, thereby reducing the overall tax bill.
There are two types of capital gains:
- Short-Term Capital Gains: These are profits from investments held for one year or less. They are typically taxed at the investor’s ordinary income tax rate.
- Long-Term Capital Gains: These are profits from investments held for more than one year. They are taxed at a lower rate, which can be 0%, 15%, or 20%, depending on the investor’s income level.
Tax-loss harvesting can apply to both types of gains, making it a versatile strategy for reducing tax liability.
Why Would Investors Use Tax-Loss Harvesting?
The primary reason investors engage in tax-loss harvesting is to reduce their tax burden. Here are the key benefits:
- Offsetting Capital Gains: If an investor has realized gains during the year, they can use losses from other investments to offset those gains. This can significantly reduce the amount of tax owed.
- Reducing Ordinary Income Tax: If the losses exceed the gains, up to $3,000 (or $1,500 if married and filing separately) can be deducted from ordinary income annually. Any excess loss beyond this limit can be carried forward to future years.
- Portfolio Rebalancing: Tax-loss harvesting can also be an opportunity to rebalance an investment portfolio. By selling off underperforming assets, an investor can reinvest in more promising opportunities, all while potentially saving on taxes.
- Improving After-Tax Returns: By reducing the tax liability, investors effectively increase their after-tax return on investment. This can enhance the overall performance of the portfolio in the long term.
How Does Tax-Loss Harvesting Work? A Real-World Example
To illustrate the benefits of tax-loss harvesting, let’s consider an example with actual numbers.
Scenario:
- Investor Profile: Sarah is an investor in the 24% tax bracket for ordinary income and 15% for long-term capital gains.
- Portfolio Composition:
- Investment A: Bought at $10,000, now worth $15,000 (a $5,000 gain).
- Investment B: Bought at $10,000, now worth $6,000 (a $4,000 loss).
Sarah wants to realize the gain from Investment A, but she is concerned about the capital gains tax she would have to pay.
Without Tax-Loss Harvesting:
- Sarah sells Investment A for $15,000, realizing a $5,000 capital gain.
- The $5,000 gain is taxed at 15% (her long-term capital gains tax rate), resulting in a tax liability of $750.
With Tax-Loss Harvesting:
- Sarah sells both Investment A and Investment B.
- Investment A: Realizes a $5,000 gain.
- Investment B: Realizes a $4,000 loss.
- The loss from Investment B offsets the gain from Investment A.
- Net Gain: $5,000 gain – $4,000 loss = $1,000 taxable gain.
- Sarah’s tax liability on the $1,000 net gain is $150 (15% of $1,000).
Results:
- Without Tax-Loss Harvesting: Sarah pays $750 in taxes.
- With Tax-Loss Harvesting: Sarah pays $150 in taxes.
Tax Savings: By using tax-loss harvesting, Sarah saves $600 in taxes.
Additional Consideration:
Suppose Sarah has no other capital gains and doesn’t use her entire $4,000 loss to offset gains. She can use $3,000 of the loss to offset her ordinary income. In the 24% tax bracket, this could save her an additional $720 in taxes, and the remaining $1,000 loss can be carried forward to future years.
Important Considerations and Risks
While tax-loss harvesting offers substantial benefits, investors should be aware of certain rules and potential pitfalls:
- Wash-Sale Rule: The IRS has a rule called the wash-sale rule, which prohibits investors from claiming a tax deduction on a security sold in a wash sale. A wash sale occurs when an investor sells a security at a loss and then repurchases the same security, or a substantially identical one, within 30 days before or after the sale. To avoid triggering this rule, investors often purchase a similar but not identical investment to maintain their portfolio’s desired asset allocation.
- Long-Term Investment Impact: While tax-loss harvesting provides short-term tax benefits, it’s essential to consider the long-term impact on your investment strategy. Selling a potentially good investment just to harvest a loss could deprive your portfolio of future gains. Therefore, it’s crucial to balance tax considerations with investment goals.
- Complexity and Costs: Tax-loss harvesting can be complex, particularly in larger portfolios with numerous investments. It may also involve transaction costs, which could eat into the tax savings. Many investors use financial advisors or automated investment platforms (robo-advisors) to implement this strategy efficiently.
Tax-loss harvesting is a powerful tool for reducing tax liabilities and improving after-tax returns. By strategically selling investments at a loss, investors can offset capital gains and even reduce ordinary income taxes. However, it’s essential to approach this strategy with careful planning, considering the wash-sale rule and the long-term impact on your portfolio.
For investors who understand the intricacies or have access to professional advice, tax-loss harvesting can be a valuable component of a broader tax-efficient investment strategy. By mastering this approach, you can turn potential losses into tax-saving opportunities, thereby enhancing your overall financial success.
