Steve Coker, CFP
Tax Loss Harvesting
This has been a tough year for many investors, but investments in negative territory may still do some good. You may be able to lower your tax bill by ‘harvesting’ losses. Tax-loss harvesting allows you to sell investments that are at a loss and replace them with reasonably similar investments. The loss may be able to offset other gains or offset up to $3,000 worth of ordinary income on your tax return.
Of course, tax loss harvesting only applies to taxable accounts, not retirement accounts such as IRA’s and 401k’s. Retirement accounts have the benefit of deferring any gains, but this also means that losses in retirement accounts cannot be deducted on the current year tax return.
Tax-loss harvesting can be hard for some investors because they have a tough time selling investments at a loss, thinking rightly that to sell at the bottom is a bad investment decision. I agree that it is dangerous to let taxes dictate your investment strategy. However, selling investments that have lost value and then immediately replacing them with similar positions, can not only make good investment sense, it can result in a lower tax bill now and in the future.
I say ‘similar’ investment because tax rules disallow a loss if investors buy the same security within 30 days before or after the sale. The IRS treats the sale as if it had never happened and the loss may not be deducted on the tax return. This is called a ‘wash sale’ because the buy and sell transactions wash each other out. The rules also disallow the sale if the investor buys the same security in another account. For example, purchasing Apple stock in your IRA to replace the Apple stock you sold in your brokerage account would be treated as a wash sale. Of course, you can avoid these rules by either waiting for 30 days or by changing the investment. The key is to find investments that are different enough to avoid the wash sale rules, but similar enough to keep your investment strategy intact.
Once a position is sold, the loss is realized for tax purposes, but the entire loss may or may not be deductible in the current year. Losses on investments are treated as ‘capital losses’ and offset gains on other investments, known as ‘capital gains’. If your capital losses exceed your capital gains in any given year, then the capital losses can offset up to $3,000 of ordinary income. If there are still unused losses, then these can be carried forward to future tax years to offset future gains or to offset up to $3,000 of ordinary income each year. These unused losses can be carried forward indefinitely to lower your tax bill in future years.
The bottom-line is that tax loss harvesting can be a great way to create a current year tax deduction or carry forward tax shield. As long as the replacement investments are chosen wisely, there is little downside to realizing the losses whenever possible. We will be looking for opportunities to harvest losses for our clients in the coming weeks as we approach year end.