While conventional wisdom often states that investments will grow over time, that isn’t always the case. Fortunately, when an investment’s return is down, there is potential for harvesting tax losses. Tax-loss harvesting may reduce your annual income tax liability.
What is tax-loss harvesting?
Tax-loss harvesting is done by selling a security that has a fair market value below its cost basis in a taxable account. This generates a capital loss. Capital losses are first used to offset capital gains. If the total capital losses for the year exceed capital gains, investors can use up to $3,000 of capital losses to offset ordinary income when they file their tax return. Any unused capital loss is carried forward indefinitely and can be used in future tax years.
Example of How Tax-loss Harvesting Works
An investor purchases $200,000 of XYZ mutual fund on January 1, 2021. On August 31, 2022, the investor decides they would like to harvest losses in their portfolio. XYZ mutual fund’s taxable cost basis is $200,000 and its fair market value is $175,000 in the investor’s portfolio.
By selling all shares of XYZ mutual fund, the investor recognizes a long-term capital loss of $25,000 (market value less cost basis). The loss is long-term because the position was held for more than one year. The long-term capital loss is first used to offset long-term capital gains then is used to offset other capital gains. Let’s assume that the investor’s portfolio had $15,000 in total capital gains for the 2022 tax year. The $25,000 loss will offset the $15,000 in capital gains so no capital gains tax will be owed. $3,000[1] of the remaining $10,000 loss will be used to reduce the investor’s ordinary income and $7,000 will be carried forward as a long-term capital loss to be used in a future tax year. If the taxpayer is in a 22% ordinary income bracket and a 15% capital gains bracket, harvesting losses according to this example would save approximately $2,910[2] in federal taxes.
When does tax-loss harvesting make the most sense?
Investors should consider harvesting losses to help offset capital gains. However, it is important to consider whether the loss investment should have a permanent place in the portfolio. If an investor wishes to purchase the security back, they should be cognizant of the wash-sale rule.
What is the wash-sale rule?
The wash-sale prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment within 30 days of the sale date. A wash sale will result in disallowing the tax loss.
Planning considerations.
Tax-loss harvesting is only applicable to taxable accounts and cannot be done in a tax-deferred account, such as a 401(k) or IRA. Tax-loss harvesting can be a silver lining to 2022’s market volatility. However, if an investor wishes to keep the security in their portfolio over the long-term, he or she should wait 31 days before re-purchasing it. Investors should consider harvesting losses from less volatile securities if they intend on repurchasing the security. This way, they reduce the risk of significant price appreciation during the wash-sale period.
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[1] The maximum net capital loss is $1,500 for taxpayers that are married filing separately. https://www.irs.gov/taxtopics/tc409
[2] $2,910 = ($3,000 x 22%)+($15,000 x 15%)
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