The Benefits of Tax Loss Harvesting
Tax loss harvesting is a tactic wherein an investor offsets capital gains from a security that is sold by selling another security for a loss, thus reducing or eliminating the net gain that is taxable as a result of the sale. Although a hallmark of long term investing is enduring the inevitable ups and downs along the way, when a portfolio is rebalanced there are strategies one can employ that may prove to be advantageous come tax time. These strategies could also contribute to improving performance in a given portfolio over time when used properly.
If realized losses exceed gains in a given year, up to $3,000 of losses can be deducted against ordinary income, and if more substantial losses were realized, the amount exceeding the $3,000 deducted can be carried forward and deducted from ordinary income in future years. There are a handful of rules to adhere to in order to properly carry out tax loss harvesting, but overall the strategy could prove to be beneficial for investors “pulling weeds” in their portfolio. Proactive tax loss harvesting can save an investor money in the long run, which in effect improves the overall return of a portfolio.
A hypothetical best demonstrates the advantages of tax loss harvesting. Assume that you decide to sell shares of Company X, which would result in a realized gain of $10,000 - for this example we will also assume that you bought and sold the stock before selling and realizing the gain within one calendar year. In that case, the gain would be taxed at your income level as a short term gain. In order to offset the capital gain, assume you sell another investment, shares of Company Y for a short term loss of $13,000. The entirety of your gain from Company X would be offset, and the remainder of the loss from Company Y could be deducted from your ordinary income level. If losses from Company Y exceeded both the gains from selling shares of Company X and the $3,000 deduction limit, the further losses as a result of selling the shares in Company Y could be carried forward to future tax years and deducted from gross income each year.
If we then apply a hypothetical tax rate of 35% to this scenario the potential tax savings as a result of tax loss harvesting is $4,550. Capital gains from selling shares of Company X were avoided, which would have resulted in $3,500 in tax, plus the deducted $3,000 from ordinary income, which would have ordinarily resulted in $1,050 in taxes.
Stretching this example one layer further, if you were to reinvest the tax savings as a result of tax loss harvesting and had losses to deduct each year, in 20 years the final investment value would be $50,086.01, if we assume 7% return. [2] That seems like a remarkable figure, and it is, but the average long term annual return of the S&P 500 is actually 10% according to James Royal, Ph.D. and Arielle O'Shea, writing for NerdWallet. [1] With initial principle of $1,050, representing $3,000 in tax deducted at a 35% rate, and an annual investment of $1,050 for 20 years, compounded at 7% for 20 years the final value is $50,086.01.
Of course, there are rules to tax loss harvesting. To continue with the example - if you sold shares of Company Y, the security wherein a loss was realized, you would not have the ability to repurchase shares of Company Y before 30 days pass; this is called the wash sale rule. You would, however, have the ability to purchase shares in a different company without being subject to the wash sale rule. The same rule applies to mutual funds and ETFs. It is also important to recognize that tax loss harvesting may only be utilized in non-retirement accounts, considering that in these accounts taxes are deferred to begin with.
Notwithstanding, the benefits of tax loss harvesting have the potential to improve the quality of holdings within a portfolio, in addition to the benefits of offsetting gains and reducing taxable income level in a given year. It is however important to utilize a selective strategy when tax loss harvesting. Through realizing gains and losses, a portfolio has the potential to become underexposed to certain sectors as a result of selling for either a gain or a loss, so it is important to rebalance accordingly to align with risk tolerance and time horizon, along with appropriate sector and geography exposure to securities. Overall, tax loss harvesting should be a tool that an investor uses when appropriate, as the potential for optimizing one’s portfolio are apparent in a host of separate cases.
Disclosures & Sources:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often neutered for investments in emerging markets. Asset allocation does not ensure a profit or protect against a loss.
Investing in mutual funds involves risk, including possible loss of principal. Find value will fluctuate with market conditions and it may not achieve its investment objective.
Stock investing includes risks, including fluctuating prices and loss of principal. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect principal.
The economic forecasts set forth in this material may not em develop as predicted and there can be no guarantee that strategies promoted will be successful.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
The Financial Consultants at Vintage Wealth Advisors are registered representatives with, and securities offered through, LPL Financial, Member FINRA/SIPC. Investment advice and financial planning offered through Financial Advocates Investment Management, DBA Vintage Wealth Advisors, a registered investment advisor. Financial Advocates Investment Management, Vintage Wealth Advisors, and LPL Financial are separate entities.