While investing in the stock market over long periods can generate significant wealth, it also comes with significant volatility. Market corrections might be more common than you think, and research from Charles Schwab shows that a decline of at least 10% occurred in 10 out of 20 years—or 50% of the time. So, as an investor, your investment portfolio will likely be down at some point. And while this may be uncomfortable, it can represent an opportunity for tax-loss harvesting.
What is tax-loss harvesting?
Tax-loss harvesting is a tax optimization strategy. You sell investments at a loss to reduce your tax bill in this strategy. You can use your losses to offset capital gains or lower your taxable income up to $3,000 per year with additional losses carried forward to future years. Then, you either repurchase a different investment immediately or wait 30 days to repurchase the same investment to avoid the wash-sale rule.
Here’s an example: Suppose you own 250 shares of Vanguard’s Total Stock Market Index Fund (VTSAX). You bought the shares at $115/ea, and now they are worth $75/ea. In other words, your investment of $28,750 is now worth $18,750. You currently have an opportunity to tax-loss harvest.
So, you sell all 250 shares, creating a capital loss of $10,000. Next, you want to make sure you stay invested while avoiding the wash-sale rule, so you take the proceeds and buy Vanguard's Total World Stock Index Fund (VTWAX). You still own $18,750 worth of stock, but you've also created a capital loss of $10,000. You can then use that capital loss to offset any capital gains for the year and take a deduction of up to $3,000 per year to reduce your taxable income.
What are the benefits of tax-loss harvesting?
Minimize your capital gains.
If you sell an investment that’s gone up in value, you likely owe capital gains tax. Capital gains rates range from 0 to 37%, depending on your income level and how long you’ve held the investment. Any investment you’ve held for longer than one year is taxed at long-term capital gains rates, and any investment you’ve held for a year or less is taxed at short-term capital gains rates.
Current tax law allows you to offset capital gains with capital losses up to any amount. So, if you sold investments and generated a $10,000 gain for the year, but you also did some tax-loss harvesting and created a $7,000 loss, you only end up paying capital gains tax on $3,000 of gains ($10,000 - $7,000 = $3,000).
Offset your ordinary income
If you have more capital losses than capital gains for the year, you can use an additional $3,000 in losses to offset your ordinary income. This can be a valuable deduction as ordinary income tax rates can be as high as 37%. For example, if you’re in the 24% income tax bracket, a $3,000 capital loss deduction would save you $720 in taxes ($3,000 x .24 = 720).
Also, while you can only deduct $3,000 in losses from ordinary income for the year, you can carry forward additional losses to future years. Those losses can offset capital gains or reduce ordinary income by $3,000.
Remove unwanted investments from your portfolio.
Another benefit to tax-loss harvesting is that you can use it as an opportunity to remove unwanted investments while creating a tax benefit. For example, if you have a particular stock or fund that you no longer want to own and it’s gone down in value, you can simply sell it, create a capital loss, and then use the proceeds to purchase a different investment.
What are the drawbacks of tax-loss harvesting?
Lowers your basis when you repurchase investments.
One of the drawbacks to tax-loss harvesting is that it often lowers your cost basis when you repurchase investments. Cost-basis is the amount of money that you pay to acquire an asset. So, for example, if I buy $100 worth of Amazon stock, my cost basis in that stock is $100. Then, if I sell it for $300, my gain is the total proceeds of $300 minus my cost basis of $100 for a total gain of $200. So, the lower my cost basis, the higher my potential gain.
With tax-loss harvesting, you typically sell investments while the market is down and repurchase them shortly after. That means the cost of assets will be lower than when you initially bought them, lowering your overall cost basis. Then, if you try to sell those investments in the future, you could be facing a higher overall tax bill because you’ve got a lower basis.
Wash-sale rule: some losses can be disallowed.
The wash-sale rule exists to stop investors from selling a security at a loss to receive the tax benefits and then immediately buying the same security. If you violate the wash-sale rule, some or all of your losses can be disallowed, eliminating the benefit of tax-loss harvesting.
According to the IRS, a wash-sale occurs when you “sell or trade stock or securities at a loss and within 30 days before or after the sale you”:
1. Buy substantially identical stock or securities,
2. Acquire substantially identical stock or securities in a fully taxable trade,
3. Acquire a contract or option to buy substantially identical stock or securities, or
4. Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.
Also, if your spouse buys substantially identical stock, you have a wash-sale, and some losses can be disallowed. A common tactic to avoid the wash-sale rule is to purchase different investments or funds after selling your securities at a loss. For example, suppose you are tax-loss harvesting an S&P 500 index fund. Instead of repurchasing another S&P 500 index fund and potentially violating the wash-sale rule, you might buy a total market index fund or total world index fund instead.
Should you tax-loss harvest?
Tax-loss harvesting can be a powerful tax optimization strategy during market downturns, but it comes with some added complexity. Investors must be careful to avoid the wash-sale rule and understand that they could be creating a larger tax bill down the road by lowering their cost basis. That said, it can provide a significant tax deduction, especially in a year with high capital gains or high ordinary income tax rates. And any unused losses can be carried forward indefinitely to offset capital gains and ordinary income.
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