Tax-Efficient Investing: Tax-Loss Harvesting
One of the easiest ways to help lower your tax bill when it comes to your investments is a strategy known as tax-loss harvesting. In a previous article we discussed how your investments are taxed, noting that in a taxable account, any securities you sell for a higher price than you purchased them for are subject to the capital gains tax. The good news is that capital gains can be offset by losses, which means that if you had recognized gains of $100, but also recognized losses (sold a security for a price lower than you purchased it) of $100, you could subtract the losses from the gains resulting in a net capital gain of $0. Of course, it can be difficult to sell something that has a loss on it, particularly if you think that the loss can be recovered, which is where the “harvesting” strategy comes in.
How It Works
Let’s say at the beginning of the year you need cash and so you sell a security that has a $5,000 gain on it (you bought it for $20,000 and it’s currently worth $25,000). Assuming your capital gains rate is 20%, you will have to pay $1,000 in taxes on that gain, but let’s assume that in the middle of the year you notice another security that you hold – a mutual fund focused on tech stocks - has a loss of $5,000 (you bought it for $20,000, but it’s currently only worth $15,000). If you sell that security you will recognize the $5,000 loss which you can then net against your $5,000 gain for a $0 gain, which will save you $1,000 in taxes. At the same time, you don’t want to lock in a $5,000 loss on that security and you believe it will recover. While the IRS will not let you buy back the exact same security, you can buy back a similar security – a different mutual fund that is also focused on tech stocks - in the meantime, and after 30 days, roll back into the original security that had the loss. In doing so, you “harvest” the loss for tax purposes, but remain invested in case the security, or in this case technology stocks, recover.
While this strategy can save you a decent amount of taxes, it also has to be done correctly. The IRS is aware of the concept of harvesting your losses to avoid taxes, and as such, has instituted a rule that prohibits you from immediately buying back the same security you sell to harvest losses (this rule also applies to buying the same security before you harvest losses). If you buy a security within 60 days (30 days before and 30 days after) harvesting losses from that same security, you create what is called a “wash sale,” which means that the IRS will not let you use the loss to cancel out any of your gains. That is why it is important to be mindful of your timing when harvesting losses. It’s also important to be mindful of what you buy back. The IRS also considers buying back anything “substantially identical” to the security you sold the same as creating a wash sale. So, for example, if you harvest a loss from an institutional share class of mutual fund X, but buy back the retail version the IRS will not allow you to use the loss. Finally, losses must be netted against "like" gains meaning that long-term losses cancel out long-term gains and short-term losses cancel out short-term gains. For more information on how tax-loss harvesting works or to find out more about other tax-saving strategies, give one of our advisors a call today.