Main Article

While we are officially in a bear market and volatility in the financial markets reigns supreme, it’s normal to worry about your finances. As a financial advisor, I feel these emotions with you and understand the impact the market volatility has on all of us. But even in bear markets, it matters where we focus our attention. One way we take advantage of this is to carry out tax loss harvesting in our client portfolios.

What Is Tax Loss Harvesting?

Tax loss harvesting helps you minimize the amount you pay in capital gains by offsetting the amount you claim as income. Essentially, when you sell an investment at a loss, you can “harvest” that loss and use it to eliminate any gains you may have from selling investments during the year. If you don’t have any gains, you can also use the losses against your ordinary taxable income as well, up to a limit of a $3,000 loss claimed per year.

Even in bear markets, tax loss harvesting can help turn investments that may be in the red into a lower tax bill and positively influence your financial plan’s long-term success. Tax loss harvesting can also help diversify your portfolio if you are holding a single investment or a concentrated position.

When Is Tax Loss Harvesting Most Valuable?

Tax loss harvesting benefits those who are in a higher tax bracket. If you are currently in a lower tax bracket and expect that you will be in a higher one in the future, you might want to save the tax loss harvesting until then. You will always need to start claiming the loss in the year it occurs, but if your losses exceed $3,000, you can carry forward this excess loss in future consecutive years. Tax loss harvesting is not a strategy to use in tax-deferred accounts, such as IRAs and 401(k)s, because gains in these accounts are not taxed.

How Tax Loss Harvesting Works

Let’s say you inherited a large amount of Apple stock from your tech-enthusiast grandmother. You’ve refrained from selling it because of the unrealized capital gain of $200,000 you would incur. And, if you are in the maximum federal tax bracket, you would owe 20%, or $40,000, of this gain in capital gains tax, plus a possible state tax liability depending on where you live.

However, you’ve also been holding mutual funds that invest in a small handful of countries. Since these funds have lost significant value in the bear market, you can sell them and realize a capital loss, in this case a loss of $250,000. This loss that would offset the $200,000 gain on your Apple stock. As a result, you would net $0 in capital gains tax this year. In addition, you’ll have $50,000 in loss you can carry forward against future gains. This allows you to use the proceeds from the sale of the Apple stock and the mutual funds to rebalance your portfolio into more diversified assets that are better suited for your long-term goals. The “paper loss” you took saved you “real dollars” in taxes while enhancing the future success of your financial plan!

Important Things to Keep in Mind

Wash sale rules. You can’t sell an investment, such as a stock or a fund, and buy it back until 31 calendar days after the sale date. This is called a “wash sale,” and the IRS will disallow your claim if you do this. For portfolios we manage, we ensure that wash sale rules are followed.

You can, however, purchase a different investment if you want to stay invested. If you have a concentrated position in just one stock or fund, you can reinvest the proceeds from the sale into a different investment. This can help rebalance your portfolio and completely avoid the wash sale issue, giving you better long-term diversification.

Cost-basis reporting. It’s important to keep accurate records of your investment purchases, especially if you purchased the same investment at different times. Cost basis is the price you paid for the investment, and it’s important for calculating the amount of tax loss you can claim.

Again, we provide cost-basis reporting for portfolios that we manage. If you have investments that you purchased prior to working with us, you will need to provide us with the cost-basis information for those investments.

Limits on the upside of losses. If you’re single or a married couple filing a joint return, you can claim $3,000 per year on losses to offset your taxable income. The limit is $1,500 if you’re married but filing separate returns. Keep in mind that if you have realized more than the limit amount for the year, you can still apply the excess losses to future years to use up the entire amount. The only caveat is that you must still be alive to claim the losses. Carryforward losses do not apply to estates, even if the individual had them at death.

Turning Lemons into Lemonade

Tax loss harvesting can be a powerful technique to take advantage of losses in a portfolio for tax savings. It is especially helpful if you can use the proceeds from the sales to rebalance your portfolio or add diversification to your asset allocation. Your advisor is available to help you decide if tax loss harvesting can be a way to “turn lemons into lemonade” during volatile market conditions.