The investing world is comprised primarily of uncontrollable factors like stock prices and tomorrow’s market movements. That’s why it’s so important to be aware of the areas you can control that can potentially put more money in your pocket.
We often talk about controlling risk with tools like diversification and an evidence-based, or “passive,” investing approach. Risk management is an important and lucrative part of investing, but you can supplement and even bulk up your returns through tax efficient strategies like asset location and – our subject today – tax-loss harvesting.
The (Ideal) Logistics
Tax-loss harvesting, when done right, is the equivalent of turning your financial lemons into lemonade, by converting your market losses into tax savings. Successful tax-loss harvesting lowers your taxes without substantially impacting your long-term investment outcomes.
Tax Savings
A capital loss occurs when you sell all or part of a position in your taxable account when it is worth less than you paid for it. That loss can then be carried into future years to offset capital gains and other income. You can use losses on a holding’s original shares, its reinvested dividends, or both.
Of course, that’s just the basics. Talk to your advisor to get a fuller understanding of all the caveats and fine print.
Your Greater Goals
Tax-loss harvesting should never take precedence over your investment plan. When we perform harvesting in client portfolios, we reinvest the proceeds of any tax-loss harvest sale into a similar position (of course, we’re careful to avoid anything that could be deemed “substantially identical”).
After that, we put the proceeds back in your original positions after thirty-one days have passed (to avoid the IRS’s “wash sale rule”).
The Tax-Loss Harvest Round Trip
Basically, what we’ve done is generated a substantive capital loss to report on your tax returns without dramatically altering your market positions. We think of it as a kind of “round trip,” that is summarized in these three steps:
- Sell all or part of a position in your portfolio when it is worth less than you paid for it.
- Reinvest the proceeds in a similar (not “substantially identical”) position.
- Return the proceeds to the original position no sooner than 31 days later.
Practical Caveats
When done correctly, an effective tax-loss harvest can boost your bottom line by lowering your tax bills. To take advantage of this, we do a comprehensive review of our client’s portfolios at least once a month to identify any tax harvesting opportunities.
But not every loss can or should be harvested. Here are a few common caveats to keep in mind:
Trading costs
Tax-loss harvesting isn’t always the right answer. If it won’t generate more than enough tax savings to offset the trading costs involved, then it’s not worth it.
I explained it as a three-step process above, but there are really four trades involved:
- Sell the holding
- Buy an interim holding to stay invested during the waiting period
- Sell the interim holding
- Buy back the original position
Each of those trades involves costs, and they could add up to more than you’d save through the harvest.
Market Volatility
When you’re ready to sell the interim holding and return to your original position, you ideally want to sell it for no more than it cost. Otherwise, you could get hit with a short-term taxable gain that could cancel out the benefits of the harvest. If the market seems to be especially volatile, it might not be the best time to initiate a tax-loss harvest, especially if your overall plan might be derailed if you can’t cost-effectively repurchase the original position.
Tax planning
A successful tax-loss harvest shouldn’t impact your long-term strategy, but it can lower the basis of your holdings once it’s completed, generating higher capital gains taxes for you down the line. It’s important that you keep your larger tax-planning needs in mind, even when you’re looking into individual harvesting opportunities.
Asset location
Remember, tax-loss harvesting only applies to assets in taxable accounts. Tax-sheltered accounts don’t generate taxable gains or realized losses.
Adding Value with Tax-Loss Harvesting
Nobody likes market downturns, but they’re an unavoidable part of investing. Losses can often be softened through tax-loss harvesting, but that’s not always the case. Figuring out if, when, and how to take advantage of a tax-loss harvesting opportunity while skirting obstacles is one way we add value for our clients.
Next, read our eBook, 12 Principles of Intelligent Investors.
