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Tax-Loss Harvesting 101: What You Need to Know

Tax loss harvesting is a strategy used by investor to lower their tax bill. Here is how it works and when you should use it.

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The concept of tax-loss harvesting is not at all new. However, modern portfolio management solutions, which are nowadays powered by top-notch computer programs, have made this strategy more popular than ever.

In a nutshell, tax-loss harvesting is a way to cut your investment losses and you should learn how it works so you can make the most out of those inevitable bad trades.

In this article, we analyze what tax-loss harvesting is and how it can be used to increase your portfolio’s return.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a tax management strategy that consists of liquidating losing positions within an investment portfolio to partially or fully offset a person’s tax bill. 

According to the United States tax code, these losses can be deducted from a person’s capital gains and can also be deducted from ordinary income by up to $3,000 per year. Moreover, any excess losses can be carried forward for later years to reduce capital gains as needed.

Tax-loss harvesting can only be applied to taxable investment accounts, not 401(k)s or individual retirement accounts (IRAs) unless they have already entered the distribution phase.

How Tax-Loss Harvesting Works

Tax-loss harvesting involves selling losing positions whenever needed to offset your capital gains. This can be easily done by logging into your brokerage account to execute the required trades.

However, in practice, doing this right might be a bit more complicated than it sounds as the timing and the securities involved may affect the outcome of the operation.

For this reason, wealth management services have created algorithms that facilitate this process for investors.

The first factor that these algorithms take into account is the tax treatment of the losses, as short-term capital losses will produce a higher tax credit. Therefore, those should be prioritized over long-term capital losses.

On the other hand, the underlying thesis behind the investment is also an important factor to consider as investors may hold on to some positions if they believe that those losses will be overturned in the future. This is often the case for buy-and-hold investors who have a long investment horizon.

In summary, tax-loss harvesting might be useful in some of the following circumstances:

  • Your investment thesis on the asset has changed
  • You have exhausted your maximum holding period
  • Your risk tolerance or financial goals are no longer the same

Meanwhile, here’s an example of how tax-loss harvesting works. Imagine you have liquidated some winning positions in a given year that produced $500 in capital gains. Now, let’s say you have been carrying some losing positions that have netted capital losses of $300. 

In this scenario, you can harvest the capital losses from your account to offset your $500 capital gain. As a result, you will only pay taxes on the remaining $200.

Things to Know About Tax-Loss Harvesting

Now that we have touched ground on the basics of tax-loss harvesting, here are some other relevant details about this practice that you may want to consider.

Wash Sales

As per the Internal Revenue Service (IRS), a capital loss cannot be claimed if the security that has been sold was bought 30 days before or after the tax-loss harvesting operation took place.

A transaction that takes place during that 30-day period is referred to as a wash sale and does not qualify to offset your capital gains.

Even though this is a clear rule, investors can still work around it by either waiting 31 days after the sale took place to buy the same security or by identifying similar financial instruments — not identical — that could provide exposure to the same industry, geography, or asset class.

Say, for example, you own shares of Exxon Mobil (NYSE: XOM) — an oil & gas company. You could sell these shares at a loss and claim the resulting capital losses to offset your tax bill while at the same time buying an oil & gas exchange-traded fund (ETF) to maintain your portfolio’s exposure to this industry.

Cost Basis Calculations

Brokerage firms allow investors to select how the cost basis of their investment is calculated. There are multiple methods for this. The most common one is the average cost method, which involves dividing the total amount invested by the number of individual securities that have been purchased.

Other methods are the actual cost, last-in-first-out (LIFO), and first-in-first-out (FIFO). Depending on which method the investor chooses, the resulting capital gains or losses may vary.

The actual cost method is the most advantageous when it comes to tax-loss harvesting as investors may opt to sell the lots that have been purchased at a higher per-unit cost to maximize their capital losses.

Make sure your brokerage firm allows you to select this method when selling securities for tax-loss harvesting purposes.

Tax Benefits

The primary goal of tax-loss harvesting is to reduce an investor’s tax bill by liquidating losing positions to generate a tax credit.

In essence, tax-loss harvesting defers the payment of taxes. However, since short-term capital losses are taxed at a higher rate compared to long-term ones, it is also possible to effectively save money in taxes if you liquidate your holdings at the right time. 

Here’s an example of how that would work. Let’s say you produced capital gains of $1,000 during a given fiscal year. During that period, you lost $1,000 on a certain investment that was made eight months ago. Since this loss is treated as a short-term capital loss, it can be taxed at the ordinary income rate (say at 37%). In that case, the resulting tax credit would be $370. 

If the investor opts to liquidate this specific investment after 12 months have passed, the capital gains tax will kick in and the resulting tax credit will be much lower, possibly at around $150 or $200.

Short-Term vs. Long-Term Loses

How much you can save on taxes via tax-loss harvesting will largely depend on which specific securities you pick to harvest capital losses.

The first factor to consider is the one discussed earlier, which involves picking the specific lots with the highest cost basis to either reduce your capital gains or increase your capital losses as much as possible.

The second factor would be the holding period. In this regard, short-term capital losses produce higher tax credits as they are taxed at a higher rate. Short-term capital losses are taxed at the same rate as your ordinary income. 

Meanwhile, long-term capital losses are taxed at a lower rate and, therefore, they produce a lower tax credit.

Finally, another benefit of tax-loss harvesting is that you can use these losses to reduce your taxable income by up to $3,000 while excess losses can be carried forward to be applied to subsequent tax reports.

Keep an Eye on Administrative Costs

Tax-loss harvesting involves the execution of multiple trades. Even though many brokers nowadays offer zero-commission trading, investors should still keep an eye on any potential costs produced when implementing this strategy. 

For example, some mutual funds may charge an early redemption fee if shares are liquidated before 30 or 90 days.

Robo-Advisors and Tax-Loss Harvesting

Robo-advisors are algorithms designed to automatically build portfolios on behalf of investors by following a set of pre-defined parameters. Nowadays, multiple financial services firms offer automated passive investing solutions that incorporate a tax-loss harvesting feature.

For algorithms and computers, it is easier to execute the most optimal trades as part of a tax-loss harvesting strategy.

Most of these firms claim that tax-loss harvesting in the long term can add some additional percentage points to the portfolio’s annualized return.

Avoid the Tax Break Trap

Once investors get to know how tax-loss harvesting works and how it can benefit them, a common mistake is to start being less thorough in the process of picking the assets that will be incorporated into the portfolio just because some of the resulting losses can be deducted.

Even though investors will inevitably make bad decisions at some point in their journey, tax-loss harvesting should not be used as a substitute for good judgment. Instead, it should be another tool to enhance the portfolio’s return.

Therefore, every addition to a portfolio should be made based on a thorough analysis of its merits as an investment opportunity in the context of the investor’s unique financial goals and risk tolerance.

When Is Tax-Loss Harvesting Most Useful?

Tax-loss harvesting is a great strategy that should be adopted by investors to optimize their portfolio’s returns by liquidating losing positions whenever convenient to reduce their tax payments.

Here’s a summary of the specific scenarios in which tax-loss harvesting can be advantageous for an investor:

  • Before the year ends: December is the best year to execute the trades required to harvest capital losses as investors will have a clearer picture of how much they stand to pay in taxes based on the gains they have produced throughout the year.
  • Once you have identified a position you would like to get rid of: As discussed earlier, tax losses should be collected primarily if an investor believes that the asset will no longer produce the results they initially expected. With this in mind, another good scenario to implement a tax-loss harvesting strategy is when your view about a certain item in the portfolio has changed.
  • If your cost basis is too high: Assets that have declined significantly from their latest highs are good candidates to be harvested. The reason for this is that investors can use the capital losses to offset their gains while at the same time reducing the cost basis of the investment.
  • If the investment was made in the past 12 months: Short-term capital losses are taxed at the ordinary income rate. Therefore, the resulting tax credit should be higher. If during those 12 months or less the investor has identified that the position should be disposed of, that period is the best to liquidate the holdings as the resulting tax credit will be the highest possible. 

Final Thoughts

Tax-loss harvesting is an interesting strategy that helps investors in deferring the taxes they would pay at the end of a given year by liquidating losing positions within their portfolios to take advantage of the resulting tax credit.

Robo-advisors and portfolio management solutions nowadays are capable of identifying the best approach at any given point and that relieves investors from having to perform these calculations manually. 

However, understanding the basic principles behind this strategy is crucial to make the most out of it while making sure that any decisions that affect the portfolio are being made after carefully considering both the investor’s financial goals and the potential tax-related implications.

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