Tax-loss harvesting is a technique that helps utilize investment losses in taxable accounts to offset gains or other taxable income. While this can be a useful tool, financial advisers should understand the pros and cons of tax-loss harvesting to ensure the maximum potential benefits for clients.
Tax-loss harvesting involves using realized losses on some investments to offset capital gains on others within an investor’s taxable accounts. If the amount of losses exceeds the amount of the gains in a given year, up to $3,000 in losses can be used to offset a person’s ordinary income for that year. Losses in excess of that amount can be carried over to and used to offset capital gains or ordinary income in subsequent years.
If done in the normal course of managing a portfolio, investors can realize some very tangible tax benefits from incorporating tax-loss harvesting into the normal portfolio review process. The danger comes when investors focus only on harvesting tax-losses to the detriment of their long-term investing strategy.
Taxes Shouldn’t Drive Investing Decisions
Tax-loss harvesting is a solid and potentially beneficial strategy for many investors. However over-zealous investors and financial advisers sometimes focus only on the tax aspect of the process.
Most financial advisers would likely agree that tax issues should not be the primary driver of investment decisions. The decision whether or not to sell a security should be made based on issues such as the client’s asset allocation, the future outlook for the security and their overall investing and financial planning strategies. While deriving a tax benefit from a losing investment is a good thing, as the saying goes, the tax tail should not wag the investment dog.
Portfolio rebalancing is an area where tax-loss harvesting can make sense. To the extent that this rebalancing involves investments held in a taxable account, looking for positions with a loss within the asset classes to be sold makes sense. These losses can be used to offset gains triggered by the rebalancing process, or that are received during the year as mutual fund distributions.
Beware the Wash Sale Rule
One rule investors and advisers need to be aware of is the wash sale rule. This rule says that the same security, or one that is substantially the same as the one sold for a loss, cannot be purchased over a 61-day period. This period extends from 30 days prior to 30 days after the sale and includes the date of sale as well.
This extends to all accounts the investor might own. For example, they can’t sell a security at a loss in a taxable account and then turn around and purchase the same holding in an IRA account during this period. Violating the wash sale rule negates the ability to use the loss for tax purposes.
The same security part is pretty clear. If you were to sell shares of General Electric GE at a loss, you couldn’t purchase shares of GE within the wash sale period. It can be a bit murky with ETFs and mutual funds. For example, if you were to sell an S&P 500 mutual fund from one fund company at a loss and then purchased another fund provider’s S&P 500 fund this would likely violate the wash sale rules. However, if you purchased a total stock market index fund, that likely would not.
Capital gains and losses are either long-term or short-term. The tax treatment is different, and categories of gains and losses are matched against each other in a particular order.
If a client has both long-term gains and losses, as well as short-term gains and losses in the same tax year, they will then need to net gains and losses of each duration against each other. First long-term gains and losses are netted against each other, as are short-term gains and losses. After this, the net long-term gain or loss is netted against any short-term gains and losses with the net number is then reported as a net gain or loss for the client’s taxes for the year.
It’s always a good idea for an adviser to do whatever is possible to minimize their client’s short-term gains through this process, as they are taxed at higher ordinary income rates.
Planning is Key
If you are looking to do some tax-loss harvesting in your client’s portfolio, planning is key.
It’s key to have a plan for the money realized from the sales of the positions with a loss. One option might be to purchase the security that will be sold at a loss outside of the wash sale window. This can carry risks, or course, such as a drastic price movement in the wrong direction.
In the case of clients who use mutual funds and ETFs, if the desire is to continue to own something that is close to the fund that was sold to harvest the losses, be sure to have a list of funds that will fit into the same asset class and provide similar performance. For example, if a large-cap stock index fund or ETF is to be sold at a loss, look for a similar fund that tracks a slightly different index that will generally provide similar performance.
It's also important to be cognizant of the fact that tax rates and client situations will change over time. Realizing a loss on a holding and buying the holding back at a lower cost outside of the wash sale window will result in both current year tax savings and a lower cost basis for the client. This may be fine, but if the holding appreciates significantly over time, this could result in a much higher capital gain and tax bill than if the holding had simply been held at the client’s original basis.
Tax-loss harvesting offers financial advisers and their clients an effective option in managing their investment portfolios and their tax liability as long as it is applied correctly and in appropriate situations.