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Tax losses can be constructive when it comes time to add up what you owe Uncle Sam. Especially when you’re in a high tax bracket and especially in years where you have gains that you’d like to offset.

Losses need to be realized before the end of the year, December 31, to qualify for that tax year. There are a few other things that you need to know to take full advantage of them.


What is tax-loss harvesting?

If you have an investment that’s lost value compared to its basis, selling it at a tax loss allows you to offset other capital gains in your portfolio. You can even use some losses against your income. If you have more losses than gains, you can use an additional $3,000 more tax loss to offset your income. Carry the remainder forward into future tax years, known as a carry-forward loss.

After freeing up cash in the portfolio from the sale, you can buy another similar security. Or use the money available to rebalance your portfolio back to its intended allocation.
Tax-loss harvesting doesn’t work for your tax-deferred accounts, so only your taxable brokerage account provides you this opportunity.


Beware the wash-sale rule when tax-loss harvesting

The IRS doesn’t let investors take a capital loss of one security against the same security gain. The wash-sale rule prevents you from buying a substantially similar investment (or even an option to do so) within 30 days of the date the loss was realized by selling the security.

It’s critical to remember that the 30-day period applies before the sale in addition to after the fact. If you’re planning to buy a similar investment, you’ll need to do so more than a month before you sell the one for a capital loss.

Even if you don’t want to reallocate your portfolio, you can still purchase a security that’s like the original investment but not substantially similar to avoid falling afoul of the wash-sale rule. Investors often buy a mutual fund or ETF in the same sector as the stock they sold to maintain the same allocation.


Costs of tax-loss harvesting

If you’re planning to harvest losses every time the market drops, tax prep will be much more difficult. Remember that you probably have shares at different cost bases within your investment because you bought them at different times.

You’ll need to have records of the basis of every share so that you can sell the correct shares to generate the loss. This is why tax-loss harvesting can be very costly in terms of actually carrying out the program!

Given the costs of trading, make sure that the loss you’re going to harvest is of greater value than the expense. If you want tax-loss harvesting to be a part of your plan, you should do it more than once a year in December before the deadline.

Instead, consider rebalancing more than once a year. As you identify securities that you need to sell to rebalance back to your allocation, you may spot some opportunities to take losses.


Harvesting losses for improving your portfolio

Taking capital losses is especially important if you end up realizing short-term gains. The short-term capital tax rate is the same as your ordinary-income rate, so it’s best to avoid them whenever possible. The long-term capital gains tax ranges from 0 to 20%, depending on your income. Selling a purchase within twelve months of buying is considered short-term, and 12 months plus is long-term.

When it comes to the mechanics of your tax return, like-losses are applied against like-gains first. Long-term losses offset the long-term gains, and then short-term losses offset short-term gains. If you have more losses in one category and gains in another, the remaining loss offsets the gains.

For example, suppose you have $20,000 in capital losses, half short-term and half long-term, to offset $15,000 in capital gains, also half-and-half. The long-term $10,000 loss offsets the $7,500 long-term gain, with an excess of $2,500 in losses. The short-term $10,000 offsets the $7,500 short-term gain, again with an excess of $2,500, so you now have $5,000 of losses.

If you’re married filing jointly, you can take up to $3,000 of these losses this year on your income tax. (For singles and filing separately, it’s $1,500.) That means you have $2,000 to carry forward into the next tax year.


Tax-loss harvesting when you don’t have capital gains to offset

You still reduce your taxes by taking capital losses because up to $3,000 can be used against your income tax every year. By reinvesting your “harvest savings” back into the portfolio, you can accumulate a bit more to compound for the next few years.

Suppose you’re in the 30% tax bracket, and you have $3,000 of capital losses you could take. The immediate savings is $3,000* 30%, which is how much you’d otherwise pay in tax, or $900. Reinvesting that amount every year for the next twenty years, assuming a reasonable average rate of return of 6%, would result in an accumulation of about $35,000.


Other tax-loss harvesting considerations

Be careful when considering capital losses against gains on mutual funds. At the end of the year, most funds pay out capital gains distributions, in addition to making others throughout the year.

While you can use capital gains to offset long-term realized gains on mutual funds, they can’t be used against short-term distributions. Those are treated as ordinary dividends, and the mutual fund company will identify which is which.

You’ve probably already figured out that this strategy works best in high marginal tax brackets. If you take a year off with no income, that’s not likely to be the right time to wield this particular tool. Younger investors who are not in the high tax brackets yet may not see much benefit.

If you’ve invested your whole portfolio in index funds, you’re not going to squeeze many tax reductions out of your tax-loss harvesting. Because these funds are not actively managed, most of the securities are held for the whole year (or longer), with very few sales to generate either a gain or a loss.

However, if you invest in actively managed funds or ETFs, or stocks, you may find more opportunities to decrease your tax burden. Turnover in actively managed funds tends to be high, and all the buying and selling generates the potential for capital gains and losses.

Note that you don’t have much control over the gains that mutual funds distribute because an equal share is portioned to every owner of shares. You also generate gains or losses when you sell the fund yourself. By contrast, stocks are entirely within your control.

Are you interested in learning more about tax-loss harvesting for your portfolio? Please feel free to give us a call at 619.255.9554 or email us to set up an appointment.




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