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Wealth & Well-Being

Using Tax-Loss Harvesting to Improve Investment Returns

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Tax-loss harvesting is a strategy that can help investors minimize any taxes they may owe on capital gains or their regular income. It can also improve overall investment returns. As a strategy,  tax-loss harvesting involves selling an investment that has lost value, replacing it with a reasonably similar investment, and then using the investment sold at a loss to offset any realized gains. 

Earlier this year, we saw sudden market drops that allowed us an opportunity to lock in losses for tax-loss harvesting purposes. Even with the market having recovered from the lows we saw earlier in the year, you may still be able to take advantage of this strategy before year-end if you have any losses on longer held securities. Keep in mind, tax-loss harvesting only applies to taxable investment accounts; retirement accounts like IRAs and 401(k)s grow tax-deferred so they are not subject to capital gains taxes. 

Understanding Tax-Loss Harvesting 

An investment loss can be used to offset capital gains tax on realized gains in an investment portfolio. It can also be used to offset taxes on ordinary income up to $3,000 per year on federal income taxes.  So even if an investor doesn't anticipate any capital gains this year, this strategy can still be beneficial. Losses can also be carried into the future indefinitely and used to offset future gains.

Capital Loss 

Sometimes an investment that has lost value can still help your portfolio. If an investment drops, you can deduct that loss, which can also help boost your total investment returns. For example, suppose an individual invests $10,000 in an exchange traded fund (ETF) at the beginning of the year. Then, this ETF decreases in value by 10% and drops to a market value of $9,000. This is considered a capital loss of $1,000. 

A capital loss occurs anytime an asset decreases in value. However, a loss is not considered realized for tax purposes until the investment has been sold for a price lower than the original purchase price. 

Suppose that the market reverses course and this investment closes out the year at $10,800. Pre-tax, this represents a 10% return (after adding in the typical 2% dividend yield). Assuming this investor is in the highest tax bracket, their after-tax return is 9.4%, which accounts for an approximately 8% gain, plus a dividend gain of approximately 1.4%. 

However, if this investor had decided to sell the investment immediately following the initial drop in price and purchased additional shares with the proceeds, they would be able to use this realized loss of $1,000 to offset either (1) taxable capital gains they were reporting or (2) taxes on their ordinary income. At the top tax rate, this could potentially save them $760 in income taxes. This would also add an additional 7.6% return to their original $10,000 investment. 

Using tax-loss harvesting, this investor's net after-tax return on their investment would now be approximately 16.6%, or equal to 9% plus 7.6%. 

Limitations to Tax-Loss Harvesting 

There are certain limitations to the effectiveness of this strategy, in addition to regulations put in place by the Internal Revenue Service (IRS), including:

1. The Wash-Sale Rule 

Investors cannot deduct a capital loss on the sale of a security against the capital gain of the same security. This is called a wash sale. Wash-sale rules prevent taxpayers from selling or trading a security at a loss and, within 30 days before or after this sale, buying the same stock or security—or a “substantially identical” one.  In the event of a wash sale, the IRS may disallow your tax write-off.

For investors that want to harvest their losses, while also avoiding any wash-rule violations, one strategy is to take an individual stock that loses value and replace it with a mutual fund or an exchange-traded fund (ETF) that targets the same industry. This will allow you to maintain a similar asset allocation in your portfolio without violating any IRS regulations. 

2. Tax Liability Threshold 

Up to $3,000 of realized capital loss can be used to reduce your taxable income in one year (if an investor's tax-filing status is single or married filing jointly). Those married but filing separately can deduct up to $1,500 in one year. Any additional loss is carried forward for use on future tax returns.

The Bottom Line 

Tax laws create the opportunity to engage in tax-loss harvesting as an investment strategy. However, tax savings should never lessen or stand in the way of your investing goals. In other words, don’t allow the tax tail to wag the investment dog. However, in some cases, your after-tax returns can be boosted by employing this strategy, resulting in quicker asset accumulation. 

However, our approach is to create a balanced strategy and review your holdings as the market fluctuates – especially prior to year-end—to make sure that we take advantage of any tax opportunities for you. 

Interested in learning how a tax-loss strategy could help mitigate your tax burden and accelerate your asset accumulation rate? Contact the advisors at Northstar Financial Planning today to learn more. 

Written by Julie Fortin in collaboration with Lexicon Content Development

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