The benefits of tax-loss harvesting
It’s even more powerful when combined with rebalancing.
Amongst other things, Benjamin Franklin is famous for proclaiming nothing in life is certain except death and taxes. But given that he lived in a time before America had an income tax, it’s understandable that he didn’t say anything about how much you have to pay in taxes or when you have to pay them.
For better or worse, today, income taxes are just a part of life. However, there are many tax-smart strategies you can use as part of a modern wealth-management plan that can lessen their impact on your bottom line.
One of those strategies is called tax-loss harvesting.
When it comes to investments, nobody likes losses. But unfortunately, they are unavoidable, and no matter how hard you try, you’ll have losses from time to time over your lifetime.
But in many circumstances, by using tax-loss harvesting, you can take those losses and use them to your financial advantage.
THE INS AND OUTS OF INCOME
Money that you earn from wages, tips, bonuses and commissions is considered to generally be ordinary income by the Internal Revenue Service. And, as the name suggests, this type of income is generally taxed at ordinary tax rates, which change depending on which tax bracket you are in.
Investment profits and losses are generally called capital gains or losses, and you can write off your capital losses against your ordinary income, but only $3,000 worth. Any capital losses over $3,000 can be used against your capital gains, and that’s where tax-loss harvesting comes in.
Tax-loss harvesting allows you to alter the timing of when you realize capital gains and losses, which can help lower your income in a particular year. But first, let’s talk about how capital gains, or profits, are taxed.
If you have profits on an investment that you’ve held for more than one year, they are taxed at what is called long-term capital gains rates. Conversely, if you have profits on an investment you’ve held for exactly one year or less, those profits are taxed at what is called short-term capital gains rates.
The tax rate you pay on both long- and short-term gains varies depending on what tax bracket you are in.
IRS rules allow you to offset capital losses against capital gains (profits). And any excess capital losses can be rolled over to the following years until they are exhausted.
HOW DOES TAX-LOSS HARVESTING WORK?
Tax-loss harvesting can get very complex, but here is a basic example of how it works:
Let’s say you sell a stock and realize a $10,000 gain. Because you held it for more than one year, those profits are taxed at long-term capital gains rates. And let’s say your ordinary income bracket puts you at the 15% long-term capital gains rate.
That means you would have to pay $1,500 in taxes on your profits.
However, if you have another stock that you’ve held for more than a year, which has an unrealized loss of $10,000, you could sell that stock, realize the loss, and then that (capital) loss could be used to offset your capital gains on the other stock.
So, if you subtract the $10,000 in long-term capital losses from the $10,000 in long-term capital gains, you have no realized gain. Which means no taxes are due, saving you $1,500.
Tax-loss harvesting can also be a very powerful strategy when used in conjunction with portfolio rebalancing.
When you rebalance a portfolio, generally, the idea is to sell outperforming assets that have become overweighted in your asset allocation, with the intent of investing the proceeds into underperforming assets that are currently underweighted in your portfolio. This can allow you to take advantage of long-term market cycles.
In the tax-loss harvesting example above, selling stock to realize a capital loss allows you to offset it against a capital gain and reduce – or potentially eliminate – taxes. But it also frees up the money that was tied up in the losing stock and allows you to reallocate it to another stock or asset class in your portfolio.
BEWARE OF THE ‘WASH SALE’ RULE
Although the IRS allows you to offset capital losses against capital gains, there is one important restriction, the wash sale rule.
When you sell an asset, like a stock, you realize the loss immediately. However, the wash sale rule says that if you buy that same stock back – or a “substantially identical” security – within 30 days of the sale, the loss is not considered “realized” and you can’t use it to offset gains.
So, for example, if you sold Apple stock for a loss, and bought it back 29 days later, or a “substantially identical” security – like Apple call options – you would not be able to use the original capital loss against your capital gains.
Tax-loss harvesting can be a valuable part of a holistic, integrated financial plan, but it can get very complex at times, so it’s best to talk to your financial planner or tax professional first to see if this strategy is right for you.
Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as tax or legal advice. Although the information has been gathered from sources believed to be reliable, we do not guarantee its accuracy or completeness.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.
Investing strategies, such as asset allocation, diversification or rebalancing, do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. All investments have inherent risks, including loss of principal. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results.