Key Tool for Minimizing Taxes 

Key Takeaways:
  • Tax loss harvesting reduces tax liabilities by offsetting gains with losses.
  • Non-qualified accounts can benefit from this strategy, avoiding wash sale penalties.
  • Direct indexing enhances flexibility for harvesting individual stock losses within an index.

 

Investors often find it necessary to sell an investment at a loss. While no one likes to lose money, one consolation is that the losses can be offset against current income or capital gains, resulting in tax savings. 

But when investors sell investments at a loss specifically in order to offset income or gains from other investments – and to “stockpile” those losses to be carried forward to future years – this becomes a strategic use of investment losses known as “tax loss harvesting.” 

Tax Loss Harvesting Explained 

Tax loss harvesting is a process used by many individual taxpayers to offset current and future tax liabilities on income and capital gains. The way it works is simple. If you have made $10,000 in capital gains on one stock market investment, and you have lost $6,000 on another investment, offsetting the loss against the gain enables you to reduce your taxable gain to $4,000.  

Both stocks must be sold in order to recognize the loss and the gain for tax purposes in the year in which the sale occurs, so with year-end approaching, many taxpayers review their investments in the fourth quarter to identify which stocks may be candidates for a tax loss harvesting strategy. 

But tax loss harvesting can benefit a taxpayer beyond the current year, since the losses can be carried forward indefinitely to offset income and investment gains in future years. This can become a strategic tax planning tool for business owners who expect to exit in the foreseeable future, for retirees looking to increase the value of their estates for their heirs or for individuals who expect to experience significant increases in income and investment gains in future years. 

Capital losses realized from tax loss harvesting can offset up to $3,000 per year of ordinary income 

By strategically selling investments at a loss today and carrying forward – or “stockpiling” those losses – taxpayers in these and other circumstances can minimize their tax liabilities for many years to come. 

Tax loss harvesting cannot be practiced with qualified investment accounts such Traditional or Roth IRAs or with retirement plans including 401(k) or 403(b)s – essentially, any retirement account that is tax advantaged. 

Non-qualified investment accounts such as individual or joint investment accounts including equities, mutual funds, ETFs, and fixed-income products are candidates for tax loss harvesting.  

Beware the Wash Sale Rule 

But it’s important to remember, when you’re selling securities at a loss, not to run afoul of the wash sale rule.  

A wash sale is a transaction in which an investor sells or trades a security at a loss and purchases a substantially similar security within 30 days before or 30 days after the sale. The wash sale rule prohibits such a transaction, to prevent investors from creating immediate capital losses to gain tax advantages while being in substantially the same position as before the loss was incurred.  

The wash sale rule applies to stocks, mutual funds, ETFs, contracts, options and all other types of securities and trading. 

Why Practice Tax Loss Harvesting? 

While reducing tax liability is the primary motivation for tax loss harvesting, the needs and circumstances of taxpayers who do it vary considerably. 

A taxpayer may anticipate a boost in income or in investment returns in the near future. Or a business owner may anticipate selling the stock of their business at a profit in five to seven years that would trigger significant capital gains and wants to stockpile losses in the meantime to minimize the tax liability they would otherwise incur in the year the business is sold. 

Or years ago, they may have bought Apple stock at $10 a share and today they’re sitting on $2 million of unrealized gains and would like to divest of the position as it now represents too significant of a risk to their overall portfolio but are reluctant to sell due to the tax consequences. If the taxpayer wants to sell those shares, having a stockpile of losses will help allay the tax liability and help reduce portfolio risk in the meantime. (On the other hand, if the taxpayer holds on until death, their heirs will receive a step-up in basis and will be able to cash out the stock tax-free.) 

Direct Indexing 

For investors who want more flexibility in their tax loss harvesting options, direct indexing offers the ability to enjoy the returns of an index while also being able to trade individual equities within the index. 

For instance, an investor can buy an Exchange Traded Fund (ETF) that tracks the S&P 500. While there might be years where the overall return of the index is positive, it is also possible that a substantial amount of the companies held in the S&P 500 are at a loss position in any given year, but since the investor owns an ETF and not those positions individually, they would be unable to benefit from recognizing the losses that those companies did otherwise incur. Instead, direct indexing allows for the investor to experience the exact same S&P 500 returns but do so by holding the individual stocks that compromise the index. Doing so ensures losses can be realized on those stocks that are at a loss throughout the year all while experiencing the same or a similar return of the index.  Once a tax advisor generates a “tax alpha” value, losses can be harvested from the ETF at whatever level the investor needs. With the ETF strategy, an investor can diversify and efficiently create losses to sell immediately or stockpile for the future. 

(“Tax alpha” can be understood by this formula: excess after-tax return minus excess pre-tax return. The result indicates the value a taxpayer can receive by a certain tax loss harvesting approach.) 

Why ‘Ordering Rules’ Matter 

Investments that are held for 12 months or less are considered “short-term investments” and their gains are taxed at ordinary income rates. Investments that are held for longer than 12 months are considered “long-term investments,” for which gains are taxed at capital gains rates of 0%, 15% or 20%, depending on the amount of total income a taxpayer has. 

Under IRS ordering rules on tax loss harvesting, losses from short-term investments must be applied against gains from short-term investments first, but remaining losses may then be offset against gains from long-term investments. The same rule applies in reverse for losses from long-term investments applied to gains from short-term investments. In other words, losses from short-term and long-term investments may be used to offset each other, but only after the ordering rules are observed. 

Tax loss harvesting is a practice that appeals to mature, conservative investors as well as younger, aggressive investors as a way to achieve maximum tax efficiency.  

If you would like to have a conversation about how tax loss harvesting can work for you, contact an Adams Brown personal financial planner. 

Please note the information provided includes references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to you to assist in understanding the issues discussed. You should consult your own attorney and/or accountant regarding the application of the information contained as to the facts and circumstances of your particular situation.