With the markets experiencing volatility, you may be hearing about the benefits of tax loss harvesting in your portfolio. The strategy of offsetting capital gains in your portfolio by selling investments that have fallen in value can help reduce your tax bill. But, before you jump in, learn more about the pros and cons of this investment strategy and whether it works for your situation.
Advantages of Tax Loss Harvesting
Given the recent long bull market, you may own stocks or other investments with substantial gains. So if you want to sell to raise cash or diversify your portfolio, you likely face significant capital gains taxes. But suppose you also own investments that have fallen in value after recent volatility. In that case, you can use those capital losses against your gain to reduce or eliminate your net capital gain within the same tax year. So, if you sell Stock A at a profit of $5000 and Stock B for a loss of $3000, your net capital gain will only be $2000.
Recently, a retired dentist told me his investment broker suggested he could use the $70,000 of harvested losses from his regular investment portfolio sales to offset the taxable income of his required IRA distributions. Not true! You can use up to a maximum of $3,000 a year in losses to offset ordinary income. But if you have accumulated more than $3,000 in losses in a given year, you must carry the remainder to future years.
If you’d like to keep the makeup of your portfolio consistent, you can purchase a similar type of investment as the holding you sold to harvest the loss. So an investor could sell the stock of a technology company at a loss and then buy a different technology stock or swap one sector-focused ETF for another.
Though many investors implement tax loss harvesting at the end of the year, a financial advisor can help you find opportunities to limit capital gains taxes throughout the year.
Tax Loss Harvesting Disadvantages
Wash sale rule: Tax loss selling is subject to the “wash sale” rule, which prohibits investors from selling an investment for the tax loss, then buying that same security or an investment deemed “substantially identical” within 30 calendar days. Because the definition of substantially identical isn’t cut and dried, navigating this rule can be tricky. If you violate the wash sale rule, the IRS won’t allow you to use the loss to offset any gains. Be careful too because selling a security in one account and then rebuying a substantially similar security within 30 days in another account, even if that second account is an IRA, violates the wash sale rules and disallows your loss.
Need to choose a replacement security: If you decide to replace the stock or other security you sell with a similar “replacement” option, there’s no guarantee your new holding will be a wise choice. Your choice of a similar security may charge higher costs or underperform the one you sold.
Can lower your overall portfolio cost basis: Tax savings you enjoy today from cash flow harvesting can bring higher taxes later. That’s because if you sell an investment and then purchase a similar security at a lower price, you lower the overall tax basis of your portfolio. When your portfolio rebounds to the original value, you face a capital gain that is the same amount as the loss you harvested previously.
For example, if you own $5000 of a technology stock that falls to $3000, which you sell at that price, you can apply that $2000 loss against a capital gain. But suppose you buy another technology stock for $3000, which eventually rises in value to $5000. In that case, you’ll face taxes on that $2000 capital gain when you sell that investment, effectively wiping out your earlier tax benefit.
Can tempt you to make investment decisions based on taxes alone: Deciding to buy or sell an investment should be made in the context of your portfolio and investing goals. Avoid selling an investment just for a potential tax break. If the holding is still worthwhile and fits your investment goals, you may be selling too soon.
Can be complicated to manage: Managing tax loss harvesting can be difficult on your own. You need to track the cost basis and potential sale price for all your investments. If you’re buying the same or similar security, you need to watch out for the wash-sale rule. Also, you need to ensure these moves make sense for your broader financial situation. Most investors should rely on an experienced financial advisor and tax professional to walk them through their options.
Can’t be used in a retirement account: Tax loss harvesting can only be used in an account subject to taxes, such as a brokerage account. Because they are tax-deferred, there is no benefit to using tax loss harvesting in a retirement account such as a 401(k) or Roth IRA.
The Bottom Line
Deciding whether to carry out tax loss harvesting is rarely a black and white decision. Be sure to weigh the pros and cons, and consider your situation before you sell a holding to harvest a loss.