Every investor faces a harsh reality: taxes can eat away at investment returns faster than inflation. What might seem like a successful year in the market can turn disappointing once Uncle Sam takes his cut. For long-term investors watching their portfolios grow over decades, this “tax drag” compounds into a serious problem.
Tax-loss harvesting offers a way to fight back. This strategy might turn your losing investments into tax winners, helping you keep more of what you earn. While it won’t eliminate taxes entirely, it can help reduce your tax burden and potentially boost your after-tax returns over time.
Understanding Tax-Loss Harvesting
Tax-loss harvesting involves selling investments that have declined in value to realize capital losses. These losses can then offset capital gains from other investments, potentially reducing your overall tax bill.
The strategy works because the tax code allows you to use investment losses to your advantage. When you sell a losing investment, you “realize” that loss for tax purposes, creating a deduction you can use against gains.
The Basic Process
The mechanics might seem straightforward, but there are important steps to follow. First, you identify investments in your taxable accounts that are worth less than what you paid for them. Next, you sell these underperforming assets to realize the loss. Finally, you reinvest the proceeds in similar but not identical securities to maintain your investment strategy.
This last step matters more than many investors realize. The goal isn’t to time the market or abandon your investment plan – it’s to stay invested while capturing tax benefits.
How Losses Offset Gains
The tax code has specific rules for how losses can be applied. Short-term losses (from investments held one year or less) are first used to offset short-term gains, which are taxed as ordinary income. Long-term losses offset long-term gains, which typically face lower tax rates.
If you have more losses of one type than gains, the excess can offset the other type. For example, if you have $15,000 in long-term losses but only $5,000 in long-term gains, you can apply the remaining $10,000 to short-term gains.
The $3,000 Rule
When your total losses exceed your total gains, you can deduct up to $3,000 of the excess against ordinary income each year. Any remaining losses carry forward to future years indefinitely. This feature can provide tax benefits for years, even decades, after you realize the losses.
Research on Effectiveness
Studies suggest that investors can expect about 0.9% to 5% more in returns from tax-loss harvesting, with those in higher tax brackets seeing benefits closer to the upper end of that range. However, the actual benefit depends on several factors including your tax bracket, the types of investments you hold, and market conditions.
The timing of when you harvest losses can also matter. Research indicates there’s a “sweet spot” for when to consider harvesting losses – typically when an investment has dropped 10% for those reviewing monthly or 15% for daily reviewers. These thresholds help balance tax benefits against the risk of being out of the market due to wash sale rules.
The Wash Sale Rule
The IRS wash sale rule presents the biggest challenge for tax-loss harvesting. This rule prevents you from claiming a loss if you buy the same or “substantially identical” security within 30 days before or after the sale.
What counts as “substantially identical” isn’t clearly defined by the IRS, which creates some gray areas. Buying shares of the same company clearly violates the rule. But what about similar ETFs that track the same index? The lack of specific guidance means you should be conservative in your approach.
Working Around Wash Sales
You can avoid wash sale issues in several ways. One approach involves waiting 31 days before repurchasing the same investment. Another strategy uses similar but not identical investments as replacements. For example, you might sell an S&P 500 ETF and replace it with a total stock market ETF.
Some investors use ETF pairs specifically designed to avoid wash sale issues while maintaining similar market exposure. However, you should consider whether the differences between the investments might affect your long-term returns. And always consult with your tax preparer if you’re unsure whether or not a wash sale rule can be avoided.
Long-Term Investment Implications
Tax-loss harvesting can have lasting effects on your portfolio that extend well beyond the immediate tax savings. When you harvest losses, you’re essentially resetting the cost basis of your investments to a lower level.
This lower cost basis means you may face larger capital gains when you eventually sell the replacement investments. If tax rates increase in the future, you might end up paying more in taxes than you saved through harvesting.
The Deferral Benefit
Even when future tax rates are higher, deferring taxes can still provide benefits. The money you save on taxes today can be invested and compound over time. This growth might more than offset the higher future tax bill, especially for long-term investors.
Think of tax-loss harvesting as getting an interest-free loan from the government. You pay less in taxes now and invest those savings. Eventually, you’ll pay the deferred taxes when you sell, but the interim growth can make the strategy worthwhile.
When It Makes Sense
Tax-loss harvesting may be most valuable for investors in higher tax brackets who expect to have taxable investment gains. The most recent IRS data indicates that more than 90% of individual filers did not recognize any net capital gains for the tax year 2020, suggesting the strategy may have limited value for many investors.
The strategy tends to work best during volatile market periods when some investments are likely to be showing losses. Bull markets, where most investments are gaining value, provide fewer harvesting opportunities.
Account Type Considerations
Tax-loss harvesting only applies to taxable investment accounts. You can’t harvest losses in 401(k)s, IRAs, or other tax-deferred accounts because these accounts don’t generate current taxable income or losses.
This limitation means the strategy may be less valuable for investors who hold most of their assets in retirement accounts. However, as your wealth grows and you accumulate more assets in taxable accounts, tax-loss harvesting becomes increasingly relevant.
Professional Management
The complexity of tax-loss harvesting has led many investors to seek professional help. Financial advisors can monitor portfolios continuously, identify harvesting opportunities, and ensure compliance with IRS rules.
Some investment platforms now offer automated tax-loss harvesting services that can capture opportunities as they arise. These services can be particularly valuable for investors who don’t have time to monitor their portfolios regularly.
However, ultimately it’s important to remember the end goal of investments: to make a net profit after tax. While minimizing taxes is important, it’s more important to choose wise investments and make your buy and sell decisions based upon long-term growth objectives.
Potential Drawbacks
Tax-loss harvesting isn’t right for everyone or every situation. The strategy can increase portfolio complexity and transaction costs. Frequent trading might also lead to unintended consequences, such as losing qualified dividend treatment on some stock holdings.
There’s also the risk that replacement investments underperform the original holdings. While you might maintain similar market exposure, small differences between investments can compound over time.
Psychological Factors
Some investors struggle with the idea of “locking in” losses by selling underperforming investments. This emotional response can prevent effective implementation of the strategy. Remember that harvesting doesn’t mean abandoning your investment thesis – it’s about capturing tax benefits while maintaining market exposure.
Work With Us
Tax-loss harvesting can be a powerful tool for long-term investors looking to minimize their tax burden and potentially improve after-tax returns. However, the strategy involves complex rules, timing considerations, and trade-offs that require careful analysis. The benefits vary based on your tax situation, investment timeline, and market conditions, making it important to consider whether this approach aligns with your overall financial goals.
At Brogan Financial, we understand that effective tax planning is an essential component of long-term investment success. We can help you evaluate whether tax-loss harvesting makes sense for your situation and implement it properly if appropriate. We’ll work with you to develop a comprehensive approach that considers all aspects of your financial picture, ensuring that tax strategies support rather than compromise your long-term objectives. Contact Brogan Financial today to learn how we can help you make informed decisions about tax-loss harvesting and other strategies to optimize your investment outcomes.
