STAFFORD, UNITED KINGDOM – AUGUST 09: Why tax-loss harvesting is best a year-round activity (Photo … [+] by Christopher Furlong/Getty Images)
If you’re a U.S. investor with a taxable account, here’s how and why to consider tax-loss harvesting. Tax loss-harvesting means realizing your investment losses early. The reason to do it is that it can push your capital gains taxes into the future. To be clear this no magical (or shady) tax avoidance scheme, but by pushing your capital gains taxes further out, you may end up achieving a better return on your savings.
Why bother? Well, a study from researchers at MIT looking at the U.S. market from 1926-2018 has found tax-loss harvesting may add a little under 1% per year to your returns on average. The gain is basically due to delaying paying certain capital-gains taxes letting your money grow more before the tax is paid.
First off, tax-loss harvesting is primarily relevant to taxable accounts, and even then only if you have income of over around $80,000. At lower capital gains may be zero for you anyway. In fact, in that scenario you may actually want to take all the capital gains you can, provided you stay under around $80,000 in income.
If you have an account that’s tax-sheltered like a 401(k) or IRA then tax-loss harvesting likely won’t benefit you because there are no capital gains taxes to be paid in the short-term.
Furthermore, using tax-sheltered accounts is generally a good idea, even without tax-loss harvesting. So don’t feel bad if you’re not in a position to tax-loss harvest, you may have a more efficient investment setup already. Give your self a pat on the back if so. You likely already have a strong investment approach and don’t have to worry about the nuances of tax-loss harvesting.
How To Tax-Loss Harvest
Then within your taxable account you look for investments that have lost money and have been held for under a year. Generally these shorter duration holdings will be subject to higher rate capital gains, which means higher offsetting losses too. You then sell these investments to realize a loss which can either offset your capital gains, or potentially cut your taxes by up to $3,000 of losses based on the current U.S. tax code.
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Then when tax-loss harvesting you want to watch out for the wash-sale rule. This gets complicated, but generally you want to avoid trading the same investment that you sold for tax-loss harvesting both 30 days before and after the sale. So make sure you are holding losing investments for at least month and not buying back into the same investment within a month after the sale.
You may have noticed that tax-loss harvesting may impact your overall investment strategy. If you sell a stock right as it falls, might that not hurt your performance?
Well, yes, it likely would. That’s why when tax-loss harvesting it can make sense to move the money from the sale into a broadly similar investment. For example if you’ve sold stock in Pepsi you might buy Coca-Cola, if you’ve sold Google you might buy Microsoft
The IRS does not want you to buy anything that’s substantially identical, and they aren’t crystal clear on what that means, but if you switch into something that will likely move in the same direction, but isn’t exactly the same, you’ll likely stay on the right side of the IRS rules.
The challenge with tax-loss harvesting is that often investors wait until December to do it. That means a lot of people can be tax-loss harvesting at a similar time. Some researchers think that may even move the markets. There’s some evidence for a ‘January effect’ where last year’s losing stocks can rally in January of the next year, maybe that’s partly a bounce after December tax-loss harvesting sales. We can’t be certain, but it’s one reason to look for tax-loss harvesting trades throughout the year rather than just waiting until December to see opportunities. Doing tax-loss harvesting year round can also let you find more opportunities in terms of loss-making stocks in your portfolio too.
So that’s a quick summary of tax-loss harvesting. Of course, it’s not appropriate for everyone, especially those on lower incomes and with tax-sheltered accounts. However, studies do suggest that correctly implemented, it may help add almost 1% to your returns each year based on U.S. market history.