At first glance, the term “tax loss harvesting” might feel like something you’d rather avoid — after all, it contains the word “loss.” Especially since we’re all sensitive to “losses” this year, with the S&P 500 down 19% through October and the NASDAQ down 31%.

But don’t let that little word fool you; tax loss harvesting is a strategy designed to help minimize the amount you owe in taxes. And it’s especially relevant during market declines like the one we’re in right now. That’s why now could be a smart time to diversify out of a concentrated stock position, swap some of your investments for less expensive ones or those that fit your values better, or make other changes to your portfolio.

Let’s go deeper. 

What is tax loss harvesting?

It’s a technique for deferring current taxes — or, in some cases (usually much farther down the road), greatly minimizing them. You might be able to use it this year if: 

• You own investments with unrealized losses (meaning they’re currently worth less than you paid for them) in a taxable investment account

And ...

• You own investments with unrealized gains (meaning they’re currently worth more than you paid for them) that you’ve been thinking about selling or shifting to other assets anyway …

• OR you have realized gains (aka capital gains, money you made from selling investments for more than you paid) from a taxable account 

If you don’t have capital gains you want to offset this year (or you think you might want to offset future losses more strategically), you can also choose to use up to $3,000 in losses to offset ordinary income taxes this year, and then hold the rest to offset capital gains in a future tax year instead.

The rules and how it works

Because capital gains increase your wealth, they typically increase the amount you owe in taxes — there’s a specific capital gains tax rate if you owned the investment for more than one year. On the other hand, capital losses (money you lose when you sell an investment for less than you paid for it) decrease your wealth, so they typically decrease the amount you owe in taxes.

If you have capital gains and losses in the same year, you can offset some or all of the gains with the losses, with a goal of reducing the amount you’ll owe in taxes that year. If you have more capital losses than capital gains, you can also use up to $3,000 in losses to offset your ordinary taxable income, and you can carry unused losses forward to future tax years, too.

A few things to be aware of: First, you only incur “capital losses” when you sell an investment for less than the price you originally paid. Tax loss harvesting doesn’t work if you’re selling investments that are down from their peak, but still worth more than you paid for them … as much as those might feel like a loss, too.

And second, it only works for the investments in taxable accounts, not retirement accounts like IRAs. You don’t pay taxes on those until you start withdrawing.

It isn’t right for everybody

Whether tax loss harvesting is right for you depends on your specific tax situation, the investments you own, and your tax rate — the benefit is generally highest if you’re currently in high federal and state tax brackets, and / or you think you’ll be in a lower tax bracket in the future (or that taxes will be lower in the future).

That complexity is the reason we don’t believe in automated tax loss harvesting for everyone, and our online investing service doesn’t use it. (You can read more about that here.) But for our private wealth clients, we recommend talking to a financial advisor and an accountant for advice on whether this kind of plan is right for you.

Tax loss harvesting strategies: How should you reinvest your money? 

If you sell investments in order to harvest losses, keeping the proceeds in cash may not be a good idea for your portfolio — especially in this inflationary environment. Your investment portfolio’s asset allocation (the breakdown of stocks, bonds, and alternatives) should be designed specifically to help you meet your financial goals. Shifting some of it into cash could hurt the performance of your portfolio to the point that it would negate the benefits of the whole technique. 

Instead, tax loss harvesting can be a smart way to minimize your current taxes while rebalancing, adjusting, or enhancing your investment portfolio. For example, maybe you want to rebalance your portfolio by reinvesting gains from a concentrated stock position into a different asset class. Or maybe you want to take this opportunity to adjust your portfolio in order to take on more or less investing risk.

You could also choose to enhance your portfolio by swapping out specific investments you don’t want anymore for those you do. Let’s say you own an international equity mutual fund that has high fees. You’ve been thinking of moving that money into a low-cost international equity ETF instead, but you haven’t done it yet because you didn’t want to owe taxes on large capital gains. Let’s also say you recently purchased some investments that lost value during the market downturn. You may be able to sell those recent investments for a loss, sell the high-fee mutual fund for a gain, use the capital loss to offset the capital gain, and invest your assets into the low-cost ETF instead.

Finally, you could choose to sell investments with an unrealized loss today with the specific intention of using it to offset gains in the future, like if you draw down your account in retirement.

Caveat: Wash sales don’t count

You can’t harvest losses on a wash sale, which is when you sell an investment and then buy the same exact one, or one that’s “substantially identical” to it (for example, if a company issues new stock simply because they reorganized). Otherwise, you’d be getting a tax benefit even though you really didn’t make any changes to your investments. Here are the rules:

• If you sell an investment, you’ll lose out on the tax benefit for that loss if you buy the same investment (or an investment that’s substantially identical to it) within 30 days before or after the sale.

• If you’re married and filed jointly, these wash sale rules apply to all the accounts in your household. So you can’t buy the investment back in another account you hold or an account your spouse holds.

The risks and opportunities of tax loss harvesting

Harvesting losses strategically may help your bottom line today, but in most cases it only defers taxes to a later date — which can be good or bad. Let’s look at why.

A tax loss harvesting example

Say your capital gains tax rate is 20%. You originally bought Fund A for $1,000, and now it’s only worth $800. You sell Fund A and have a capital loss of $200. Then you decide to use that loss to offset a $200 capital gain from another investment. Instead of owing $40 in taxes (20% of the $200 capital gain), now you owe $0. So, in effect, your tax savings is $40. 

Now let’s say you reinvest the $800 into Fund B, which is similar to Fund A, so that your target asset allocation stays on track. For simplicity of math, since Fund A and Fund B are similar to each other, let’s assume their performance is the same. 

Fast-forward two years, and Fund A and Fund B have both recovered — they’re each back at $1,000. If you were to sell your shares of Fund B now, you’d have a capital gain of $200, and you’d owe capital gains taxes on it. So, basically, you just deferred paying taxes for two years.

That could be neutral, good, or bad, depending on whether your capital gains tax rate has changed. If it’s held steady at 20%, you still owe $40 in taxes in this future scenario. On the other hand, if your tax rate has dropped during those two years — say, to 15% — then you’re better off, because you only owe $30. 

But what if the government had raised capital gains tax rates for your income bracket — say, to 25%? Then you’re worse off in this future scenario, because you passed on the chance to pay $40 in taxes two years ago only to owe $50 two years later. (This is one of the main risks of tax loss harvesting: There’s no way to predict how taxes might change down the line.)

Minimizing taxes instead

Deferred taxes can be minimized in two ways. (Actually, you can use these strategies to minimize taxes whether you harvest losses or not.)

First, you could donate the appreciated investments to charity. In that case, you wouldn’t owe capital gains taxes on them. Second, in your will, you could leave the investments to your heirs, who wouldn’t have to pay capital gains taxes on the appreciation (the difference between what you paid for the investments and what they’re worth on the date of inheritance), which would help minimize any capital gains taxes your heirs might owe if they sell the asset later.

We can’t control what happens in the markets. But we can explore strategies to optimize our investment portfolios during this downturn. It’s a smart idea to work with your advisor and accountant to see how tax loss harvesting might be able to help you this year.

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Disclosures