In order to be a successful investor [1], one has to learn how to buy low and sell high. This can be hard since many of us allow for our emotions to get involved. As a result, we tend to buy high and sell low. But even when the buy low, sell high strategy is followed, there are times when it makes sense to sell low. When you strategically sell low in order to offset gains realized with other investment holdings, you apply the technique known as tax loss harvesting. Let’s walk through the various benefits of tax loss harvesting.
What is Tax Loss Harvesting?
As I mentioned above, tax loss harvesting [2] is when you sell a security for a loss. While on the surface this doesn’t make much sense, the benefit will be clear in an example. Let’s say I have two holdings, A and B. Holding A has produced a short term capital gain distribution for me. On the surface a capital gain payout is a good thing, but the downside to short term capital gain distributions is that the payout is taxed at ordinary income levels [3]. Therefore, if you are in the 28% tax bracket [4], you will be taxed at 28% on that short term capital gain.
You can offset your investment gains with your losses. However, the IRS allows you to offset up to an additional $3,000 in income each year with investment losses. If I sell a portion of Holding B for the same amount as the short term capital gain distribution of Holding A, I offset that gain with my loss and don’t incur any taxes. In essence, I just saved myself 28% since I am in the 28% tax bracket.
Benefits of Tax Loss Harvesting
- Tax Savings.
The first benefit of tax loss harvesting is the tax savings. Whatever amount of short term gains I can offset through selling “losersâ€, saves me on my taxes. Note that I don’t even need to have capital gains to save on taxes. Assume that I have no gains this year, but I sell a fund that I lost $3,000 on. I can apply that $3,000 towards my ordinary income, reducing the taxes I owe there. If I were in the 25% tax bracket, that $3,000 loss saved me $750 in taxes. - Carry-forward Benefit.
Another benefit of tax loss harvesting is the carry-forward benefit. Remember how I told you that you can offset $3,000 annually? Well if you have $5,000 in losses this year, you can apply $3,000 worth of the losses this year against your taxes and the remaining $2,000 in the next year. Just because you can only offset $3,000 per year doesn’t mean you lose any additional losses. You carry that amount forward until you are able to use it. I’ve known people that have $15,000 worth of losses that they carried forward for many years. - Potential Higher Returns.
Taking advantage of tax loss harvesting can allow you to realize a higher return. For example, let’s say you bought a mutual fund for $10,000 and you plan on holding it for a long time. But a few months after buying it the stock market drops and your $10,000 is only worth $7,000. You sell the fund and wait 31 days (more on the reasons for this later) and then buy back into the fund. At the end of the year, assuming you have no capital gains, you have a realized loss of $3,000 that you can write off of your taxes.That $3,000 is worth $750 to you if you are in the 25% tax bracket. With your reduced tax liability, you take the $750 and invest it back into your mutual fund. You then hold the fund for 10 years and it earns 7% annually for you before you sell it. After those 10 years, you have $15,375.16 as seen below:
$7,000 + ($15,245.42-$7,000) * .85 + $750 + ($1,475.36 – $750) * .85 = $15,375.16
Note that this assumes you are paying 15% in long term capital gains taxes. The $15,245.42 is what the $7,000 grew to in the 10 years and the $1,475.36 is what that $750 grew to. How much would you have if you didn’t sell your fund and held for the entire 10 years? You would end up with $14,458.61:
$10,000 + ($15,245.42 – $10,000) * .85 = $14,458.61
By taking advantage of tax loss harvesting, you earned an additional $916.55. This is all from the $750 that you were able to invest because of tax loss harvesting. If you held onto this fund for longer than 10 years, the difference would be even greater.
Notes About Tax Loss Harvesting
Wash Sale Rule. There are a few things you need to know about tax loss harvesting before you jump into it. The first is the wash sale rule. Without going into great detail, a wash sale is when you sell a mutual fund (or other investment) for a loss and buy back the same fund (or investment) within 30 days before or after the sale. If you do this, the IRS does not allow you to recognize any loss you realized on the sale of the mutual fund (or investment).
Taxable Accounts Only. Secondly, tax loss harvesting only makes sense in a taxable account. Since your retirement accounts, such as a 401(k), 403(b), Traditional IRA [5] or Roth IRA [6] accounts, are all tax deferred, you get no benefit of tax loss harvesting since any gains in these accounts aren’t taxed until you withdraw the money.
Final Thoughts
There are many benefits to taking advantage of tax loss harvesting. When I worked in a high net worth investment firm, we placed tremendous emphasis on tax loss harvesting as a way to reduce our client’s tax liability. Many times when we first did tax loss harvesting, our clients would question why we were selling so called “losers†and realizing a loss. Once we explained the benefits of this practice, and they saw the benefit when completing their taxes, they were on board 100%. I encourage you to analyze your investments to see if there is an opportunity for you to take advantage of tax loss harvesting.