Year-End Planning: Tax-Loss Harvesting

Market fluctuations are a natural part of investing, and it's not uncommon for some of your investments to lose value during periods of volatility. When this happens, you can capitalize on portfolio losses by selling underperforming investments. The proceeds from the sale can then be reinvested into similar funds to keep your portfolio aligned with your long-term financial plan. But the real benefit goes beyond maintaining your asset allocation – by realizing these losses, you can offset capital gains you’ve earned elsewhere in your portfolio, reducing your overall taxable income. This process is known as tax-loss harvesting.

How does tax-loss harvesting work?

Tax-loss harvesting involves selling a security that has decreased in value and then using the proceeds to purchase a similar security. The loss you realize from this sale can be used to offset existing or future realized capital gains. If you don’t have any capital gains, the IRS allows you to offset ordinary income with up to $3,000 of losses per year. Anything over $3,000 can carry forward indefinitely (as of 2023). It’s important to note that tax-loss harvesting only benefits taxable accounts, as this strategy has no advantage in tax-deferred or tax-exempt accounts.

Let's look at this with some real numbers.

Client Example:

• While rebalancing your portfolio, you sell Stock A for a realized capital gain of $30,000. You also sell Stock B for a realized capital loss of $40,000.
• $30,000 in gains - $40,000 in losses = ($10,000) losses
• In this case, you could use up to $3,000 of your losses to reduce your taxable income for the year. The remaining $7,000 of losses can offset future gains and income.

Considerations Before Using Tax-Loss Harvesting

THE “WASH-SALE” RULE

The wash-sale rule is one fundamental rule to be aware of when engaging in tax-loss harvesting. The IRS prohibits selling an investment at a loss and buying a “substantially identical” security in its place within 30 days of the sale. This rule prevents taxpayers from solely selling a security to create a tax-deductible loss and immediately repurchasing it.

What can investors do to avoid triggering this rule? One way is to wait 31 days before repurchasing the same security. Another option is to purchase a similar but not identical security. For example, you sell Home Depot stock at a loss and immediately reinvest the proceeds in Lowe’s. This is not a violation of the wash sale rule and is a classic example of tax-loss harvesting. Lowe’s and Home Depot are both in the business of home improvement, but they are not “substantially identical” because they are different enterprises.

TAX-LOSS HARVESTING IS A TAX DEFERRAL STRATEGY

Investors may overestimate the benefits of tax-loss harvesting if they focus only on the immediate tax deduction, so they must thoroughly consider future tax implications.

Client Example:

• You bought Stock C for $10,000, but it’s now worth $6,000.
• You sell Stock C at $6,000, realizing a $4,000 loss.

Immediate Tax Benefit:

• You can use the $4,000 loss to offset any capital gains you have this year.
• If you have $4,000 in short-term gains, the loss will cancel them out, reducing your taxable income.
• At a 40% tax rate, you will save $1,600 on your taxes this year (40% of $4,000). This $1,600 stays in your portfolio, potentially increasing returns.

Future Tax Impact:

• If you decide to buy Stock C back at its current price of $6,000, your new cost basis will be $6,000.
• Later, if Stock C goes up in value and you sell it for $12,000, your gain will be calculated as:
  
  • Sale Price: $12,000
  • New Cost Basis: $6,000
  • Capital Gain: $12,000 - $6,000 = $6,000
• This $6,000 gain is $2,000 higher than if you hadn’t sold and repurchased the stock. You’ll owe taxes on this larger gain when you sell it in the future.
• Today’s $1,600 tax savings is a tax deferral – you’re delaying taxes, not reducing them.
  The Bottom Line: Tax-loss harvesting is more of a tax-deferral strategy than a tax-reducing one.

The Benefits of Tax-Loss Harvesting

The end objective of tax-loss harvesting is that less of your money goes to taxes, and more may stay invested to compound over time. A few other benefits of tax-loss harvesting include:

1. Tax bracket arbitrage in tax-loss harvesting: Tax bracket arbitrage can create additional wealth opportunities through tax-loss harvesting. This is the strategy of harvesting tax losses when an investor is in a higher tax bracket and then benefiting from those losses in the future when they are in a lower tax bracket. This strategy can greatly amplify the benefits of tax-loss harvesting, highlighting the importance of a long-term financial plan that anticipates future cash flows and tax bracket changes.
2. A long-term holding amplifies tax-loss harvesting: Tax-loss harvesting can be especially beneficial if you hold your portfolio until death. By deferring taxes over many decades, your tax savings continue to grow. When your beneficiaries inherit your portfolio, they receive a step-up basis, which means they won’t have to pay taxes on any unrealized gains built up during your lifetime.
3. Tax-loss harvesting and charitable giving: You can benefit by using harvested securities for charitable donations in a few ways. First, you realize the tax savings from the loss you harvested. Second, by donating the securities directly, you avoid paying higher taxes on future gains, as the donation is tax-deductible at the current value.
4. Portfolio rebalancing: Tax-loss harvesting can help you rebalance your portfolio by strategically selling underperforming assets. This helps you “cut your losses” while potentially reducing tax liability and improving portfolio performance.

The Drawbacks of Tax-Loss Harvesting

Tax-loss harvesting is less of a “silver bullet” and more of a well-aimed shot at long-term savings. There are various risks associated with tax-loss harvesting:

1. Divergence in performance between the primary security and the substitute security (“tracking error risk”): Tracking error is the difference between the performance of the security sold and the substitute security purchased. The risk comes from the fact that even though the two securities may be similar (e.g., both are technology stocks), they may not zig and zag the same way. The way to mitigate tracking error risk is by selecting substitute securities with a high probability of tracking closely with your original security over a long period.
2. Fees incurred while harvesting: Selling one security and buying another involves two separate transactions, each incurring a fee. There is also the potential that it is best to buy back the original security after the 30-day wash-sale period has ended, resulting in four total transactions. It is important to make sure that the fees associated with harvesting do not outweigh the economic benefits.

How Wealthspire Executes Tax-Loss Harvesting

We consider all the benefits and risks when determining if we should harvest losses in our clients’ portfolios. While we can never eliminate the risks associated with tax-loss harvesting, we can reap the benefits of harvesting losses while minimizing such risks on behalf of our clients. This is because Wealthspire:

• Invests for the long term
• Negotiates low transaction costs with our custodians
• Constructs diversified portfolios, which increases the likelihood of having more “losers” available to harvest
• Often employs separately managed accounts (SMAs), which consist of individual securities (stocks and bonds) directly owned by the client. This customized approach provides greater control over tax management and makes it easier to tax-loss harvest across a wide range of individual holdings.

Key Takeaways

• Tax-loss harvesting is a tax-deferral strategy that provides long-term investors with greater after-tax returns.
• Tracking error, fees, time horizon, tax situation, and security holding period are all factors to consider when considering tax-loss harvesting.
• Opportunities for harvesting losses aren’t always available. The opportunity naturally occurs when you own a diversified portfolio in an ever-moving market.

Sources:

https://investor.vanguard.com/campaign/tax-loss-harvesting-could-mean-more-savings  
https://www.kitces.com/blog/evaluating-the-tax-deferral-and-tax-bracket-arbitrage-benefits-of-tax-loss-harvesting/
https://www.fidelity.com/viewpoints/personal-finance/tax-loss-harvesting 

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