UNLOCK THE BENEFITS OF A TAX LOSS HARVESTING STRATEGY

It’s even more powerful when combined with rebalancing.

Article published: February 05, 2024

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 your investment portfolio, losses can sting. But, unfortunately, they are unavoidable, and no matter how hard you try, you’ll have to face the occasional investment loss from time to time.

But in many circumstances, by using a tax loss harvesting strategy, you can take a realized loss and turn it into a financial advantage for that tax year.

 

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 income typically comprises dividends (both ordinary and qualified), interest and capital gains (short-term and long-term). Generally, these are taxed at ordinary income tax rates. However, qualified dividends and long-term capital gains benefit from more favorable tax treatment, as they are taxed at capital gains tax rates.

A “short-term capital gain” refers to the profit you make from selling an asset that you've held for one year or less. A short-term capital gain is usually taxed at your federal ordinary income rate, which tends to be higher than the long-term capital gains tax.

A long-term capital gain, on the other hand, requires the investor to have held the asset for at least more than a year. These gains have their own tax rate depending on your total taxable income – though it’s often less than your ordinary income tax rate.

For instance, here is how capital gains tax will be calculated in tax year 20241:

Long-Term Capital Gains Tax Rate

Single/Married Filing Separate

Married Filing Jointly

Head of Household

0%

$0 - $47,025

$0 - $94,050

$0 - $63,000

15%

$47,026 - $518,900

$94,051 - $583,750

$63,001 - $551,350

20%

$518,900+

$583,750+

$551,350+

 

However, it is possible to offset some of your taxes with any capital loss you had throughout the year, and that’s where the strategy of harvesting losses comes in. 

 

What Is Tax Loss Harvesting?

Tax loss harvesting allows you to alter the timing of a realized loss, which can help lower your income in a particular year. How exactly?

This strategy involves selling investments that have experienced a loss to lower the amount you’ll have to pay in capital gains tax. IRS rules allow you to offset capital losses against capital gains (profits). If you have capital losses, you can use them to offset an unlimited amount of capital gains. If your capital losses exceed your capital gains, the excess loss can be used to offset up to $3,000 ($1,500 if married filing separately)2 of ordinary income per year. Any excess capital losses over $3,000 can be rolled over to the following years until they are exhausted.

 

The Benefits of Tax Loss Harvesting

Tax loss harvesting offers several key benefits for investors, most notably the potential reduction of capital gains taxes. This strategy is particularly advantageous in years when your investment portfolio performs well, as the harvested losses can significantly reduce your overall tax liability. Additionally, if you have sold real estate, a business, or any other asset that created capital gains income, then utilizing tax loss harvesting could help lower your taxes.

This strategy can also be used as an opportunity to reinvest in growth-oriented assets or make adjustments to your investment strategy. For instance, by selling underperforming assets, you can not only realize losses for tax purposes, but free up capital that can be reinvested. Whether directed toward assets with better prospects or toward rebalancing your portfolio to better align with your risk tolerance and investment goals, this strategic reallocation can help improve performance over time.

 

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 as a long-term gain. And let’s say your total taxable income 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 (long term or short term), which has an unrealized loss of $10,000, you could sell that stock, turn it into a realized 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 capital losses from the $10,000 in long-term capital gains, you have no realized capital gain, which means no capital 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 overweight 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 shift your investment strategy or just 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 and 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.

 

1 Internal Revenue Service. (2023, November 27). Internal Revenue Bulletin: 2023-48. Retrieved January 30, 2024, from https://www.irs.gov/irb/2023-48_IRB#REV-PROC-2023-34

2 Internal Revenue Service. (2024, January 11). Topic No. 409, Capital Gains and Losses. Retrieved January 11, 2024, https://www.irs.gov/taxtopics/tc409



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