If you’re like many investors, you felt the impact of this year’s market correction. Perhaps you experienced losses in certain asset classes, or saw specific investments fall in value. Your first reaction may be emotional, or you may feel there isn’t much you could do about it. But what if I told you that a market correction could deliver a hidden benefit – a benefit that you may be able to leverage to save on your taxes? This benefit is called tax loss harvesting, and it could be a valuable tool for many investors this year.
What is tax loss harvesting?
Tax loss harvesting is a short-term strategy which involves the sale of stocks, bonds and mutual funds, in taxable accounts, that have lost value in order to offset taxes owed on capital gains and income. Regardless of what you sell, you cannot purchase the same asset (or a “substantially identical” asset) for a period of at least 30 days. That being said, if all or most of your investments are in your 401k or IRA accounts, tax loss harvesting will not be an option for you. Only accounts that are taxable can qualify for this strategy. Following are the basics of tax loss harvesting:
- Investor holds an investment in his or her portfolio which has experienced a significant loss.
- Investor is looking for a way to reduce taxable income. Many high-net worth individuals find themselves in the highest tax bracket, 39.6%, so this reduction can mean large tax savings.
- Investor sells the asset(s) in his or her portfolio that experienced the loss.
- The amount of the loss serves as a deduction against capital gains, or a deduction against taxable income (if the investor has no capital gains), thus reducing taxes owed for the calendar year.
The amount you can deduct depends on several factors, including:
- Whether or not you’ve experienced a capital gain for the year
- Whether any gains are short-term or long-term gains
The tax loss harvesting process
To best illustrate the process of, and potential savings that result from, tax loss harvesting, let’s consider a couple of examples:
Example 1 – Investor realizes a significant long-term capital gain
In our first example, the investor has sold a business he’s owned for many years. Excited about the prospect of moving on to his next phase, he’s also concerned about the large tax liability he’s facing as a result of the sale. What strategies can he put in place to lower the tax bill? During a review of his portfolio, we recognized that the investor had an investment that is currently underperforming – an investment we could sell at a loss to take advantage of tax loss harvesting. Here’s how the numbers worked out:
|The Capital Gain: Client sells his business||$500,000|
|Sale of Investment at a Loss||($30,000)|
|New total capital gain ($500,000-$30,000)||$470,000|
|Tax on the original $500,000 Long Term Capital Gain||$119,000|
|Tax on the new $470,000 Long Term Capital Gain||$111,860|
As you can see, the client was able to reduce his tax bill significantly by leveraging the tax loss harvesting strategy.
Example 2 – No capital gains are present for the taxable year
So what happens if you haven’t realized a capital gain, or your losses outweigh your gains? You may still deduct up to $3,000 of capital losses per year from your income. In other words, if you sell an investment at a loss and have no other capital gains, you may deduct up to $3,000 from your taxable income for that year. In this example, if are in the 30% tax bracket, this could be a potential savings of $900 in taxes. If your losses total over $3,000 for the year and you still have no other capital gains, you can carry-forward the excess loss and apply it to future years’ gains or income. For example, if your losses are $5,000, you may deduct $3,000 for the current year and carry-forward the excess $2,000 to use as a deduction against income or as an offset against capital gains in a future tax year.
Deciding what to sell
There are many things to keep in mind as you consider which assets to sell at a loss for tax-loss harvesting purposes:
- Analyze your portfolio to identify any asset classes or individual investments you hold which no longer fit your overall strategy.
- Know that you may re-purchase an investment after 30 days following the sale, so consider what that investment may be doing 30 days from now. If you believe the current price will hold steady (or even decrease), and it’s something you’d like to hold in your portfolio long-term, it may be a good candidate to sell at a loss now.
- Make sure that you understand and have records for your original purchase price so that you can accurately calculate what your loss will be before selling. This will assist you in making an educated decision.
When tax loss harvesting may not be a good choice for you
Like any investment strategy, and the decisions associated with that strategy, there are scenarios where tax loss harvesting may not be a wise choice. Consider:
- The 30-day outlook for the investment you’re selling A potential risk with tax loss harvesting is how that investment may perform during the 30 days following the sale(as you may re-purchase the asset at the 31 day mark if it is still appropriate for your portfolio). If you are convinced that the price of the investment may increase by more than the tax benefit you’ll receive, then it is not wise to sell it today.
- Your tax bracket If you are in a lower tax bracket, tax loss harvesting may not be an appropriate strategy for you. The taxable benefit realized may not be significant enough to justify selling an investment at a loss.
- Actively managing your portfolio Tax loss harvesting is a short term strategy, and investors must be keenly in tune with when (and if) they should get back into the investment being sold, or into the market in general. Regardless, investors should account for the potential changes to asset allocation within the portfolio that may occur as a result of selling the particular asset.
- What to do with the cash from the sale of the investment Some investors hold onto the cash and keep it out of the market for a period of time, while some invest right away in another investment (remember, you cannot purchase the same or “substantially identical” investment for 30 days). Regardless, you’ll need to have a plan, and that plan shouldn’t include taking the money and spending it!
Tax loss harvesting can be a powerful strategy, but it comes with many considerations based on your particular situation. Whether you’re learning of it for the first time in this article, or have thought about tax loss harvesting for some time but didn’t quite know which way to go, the Krilogy team may be able to help you make an educated decision about whether a tax loss harvesting strategy may, or may not, be a fit for you.
Krilogy Senior Advisor Patrick Monahan also contributed to this article.