In times of financial uncertainty and market volatility, it’s natural to feel concerned about your finances. As a financial advisor, I share these emotions and understand the impact market volatility has on all of us. But even in bear markets – when assets plummet 20% from recent highs – 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 is a strategy that involves selling investments that have decreased in value to record a loss for tax purposes. This can help reduce the capital gains taxes owed for the current year. By selling an investment at a loss, you can “harvest” that loss to offset any gains from selling other investments that have increased in value during the year. You can also apply these losses against your ordinary taxable income, up to a limit of $3,000 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 hold 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 in a lower tax bracket now but expect to be in a higher one in the future, you might want to delay tax loss harvesting until then. You will always need to start claiming the loss in the year the investment is sold, but any unused capital losses can be carried forward to offset gains in future years. Tax loss harvesting is not a strategy to use in tax-deferred accounts, such as IRAs and 401(k)s since gains in these accounts are not taxed.
How tax loss harvesting works
For example, let’s say your tech-enthusiast grandmother gifted you a large amount of Apple stock. 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 Medicare surtax and 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 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 be able to offset ordinary income from other sources for $3,000 and have $47,000 in loss to 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 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 loss if you do this. For portfolios managed by Mercer Advisors, we ensure that wash sale rules are followed. You can, however, purchase a different investment if you want to stay invested. 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. Mercer Advisors provides cost-basis reporting for portfolios that we manage. If you have investments that you purchased prior to working with Mercer Advisors, you will need to provide 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. 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 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. Contact your advisor for more information. If you are not a Mercer Advisors client and want to learn more, let’s talk.
