The Magic of Tax-Loss Harvesting
Tax-Loss Harvesting is like the magician pulling the rabbit out of the empty hat. That rabbit you didn’t see comes as a reduction in taxable income. And you keep your investment strategy intact if you have a similar alternative to rotate into.
BCR holds a strong belief that your equity investments should always have a long-term time horizon. I tell this to new clients as they come onboard to work with us. I remind clients, both accumulating and distributing, who call nervous during bear markets, that none of their equity investments are assigned the goal of being distributed back to them over the next few years. There is ample time for them to recover and compound.
It is a very emotional experience to see your hard-earned money currently worth less than your original investment. But instead of selling low and hiding your money in cash, what if you could sell low and lower your taxable income?
If you dollar-cost average (DCA) into a taxable investment account, then it is reasonable to assume you have some unrealized losses after the rapid decline in equity prices from COVID-19 fears. There is a technique called tax-loss harvesting that is always available to investors with losses in a taxable investment account. What does that mean exactly?
- If you sell a security for a loss, you can immediately reinvest the proceeds from the sell into another security
- If the security bought is “not substantially identical” to the security sold, you can deduct the loss on your tax return. This tax term is broad and provides for some opportunities to reinvest in “similar” funds that are not “substantially identical”.
Buying a substantially identical fund after a sale for a loss would be considered a wash sale. You would not be eligible to recognize the realized losses on your tax return. This is one of the most important details to pay attention to when executing a tax-loss harvesting strategy.
The other extremely important point is that you can only execute this strategy in taxable investment accounts. This excludes all IRA’s, employer provided retirement plans like 401(k)’s and any other tax-deferred investment vehicle. These accounts have tax qualifications wrapped around them that renders this strategy useless.
There is a somewhat complicated method for netting the gains and losses against each other. But once the capital gains have been offset with capital losses, you can reduce your ordinary income, but this is capped at $3,000 per year. You can also carry forward any losses not recognized in this tax year indefinitely. This means the losses recognized will not be wasted.
Like all investment management and financial planning strategies, your individual situation determines the best strategy for you. So, when should you sell low?
- If you have short-term capital gains from another investment to net against
- If you have long-term capital gains in another investment to net against
- This might happen when you have a security you have held a long time, has an unrealized gain, and you wish to close out of the position. Reducing a large, concentrated position in employer stock to diversify is an example here.
- If you are expecting to incur long-term capital gains soon like selling an investment property or closely held business
- If you have a similar fund you can rotate into to keep your asset allocation intact. Then you get to reduce your taxable income by $3k each year.
It is important to have an appropriate alternative to rotate into. You do not want to sell just because you have losses. It is more important to maintain a diversified asset allocation than it is to reduce your taxable income by $3k.
Like with all tax planning, you want to work with your financial advisor and/or accountant to ensure you follow the rules. But for anyone who has invested in equities over the past couple of years, an opportunity likely exists to reduce your taxable income. This might be one of those rare occasions when it makes sense to sell low.