By Xavier Brenner Harvesting tax losses to offset capital gains is sometimes held up as an effective way to minimize your tax hit. The basic idea: Sell losing investments before year-end to reduce the tax liability on capital gains on your winning investments. Tax-loss harvesting is most common in the fourth quarter of the year, when investors are looking for quick ways to minimize his or her tax liability to Uncle Sam.
There's no question that tax-loss harvesting is worth a serious look in some cases. If you have a holding that has completely flamed out and see little chance of a comeback, this approach may have merit. However, the overall benefits of tax-loss harvesting can be overstated. There are a number of tradeoffs and risks that may impact investors. Here are three big ones.
1) Diversification risk
Selling a stock with a depressed value exclusively for tax reasons may not be a wise move if you believe the company has great prospects or plays a crucial role in your portfolio's diversification strategy. Assets that are down aren't always a disaster. If you believe in the company's prospects, it might actually make sense to double down and buy more. In other words, there's an the opportunity cost of resigning from the field of play when a stock you wish to own is down, maybe only temporarily.
2) Backfire Risk
Sometimes investors playing the tax-harvesting game get burned. One common strategy is to sell a holding for a tax savings advantage but then use the proceeds to buy something else that can serve as a proxy trade. This is risky on two fronts. First, the IRS does not allow dumping a stock for tax purposes and then turning immediately around and buying it back. This is known as a wash sale. Specifically, you can't buy the same security (or a “substantially identical” security) for about 30 days.