Nobody likes investment losses, but they come with a silver lining: They can help you slash your tax bill.
The tax code allows investors to use losses realized when investments are sold to cancel out taxes on gains. Tax-loss selling, also known as tax-loss harvesting, can be especially appealing during protracted market declines of the type we’ve experienced during 2022. Not only can harvested losses be used to neutralize recently booked profits, but they can also be stockpiled to offset future tax liabilities on capital gains—and even a portion of non-investment income such as wages.
While tax-loss harvesting can help ease the sting of losses, it’s not appropriate for all types of investment accounts. And there are situations in which it’s best avoided.
How Tax-Loss Harvesting Works
To offset tax liabilities, investors must sell a portfolio holding and book a capital loss—the difference between the investment’s purchase price and its sale price. Those losses can be used to neutralize the corresponding amount of taxes on gains earned from selling holdings that have appreciated in price.
For example, you sell Stock A—let’s say it’s a construction company stock—and book a loss of $1,000. You also sell Stock B—perhaps an energy stock—for a gain of $1,000. The loss in that case could be used to cancel out the entire tax bill for the gain on Stock B. Stocks that have been held for under a year are subject to a higher capital gains tax rate than stocks held longer than a year, so it’s most impactful to cancel out those short-term gains first. That being said, long-term investors shouldn’t make a habit of short-term trading: Patience is generally a far more reliable tool for achieving one’s investment goals.
The Benefit of Flexibility
It’s worth noting that losses from one kind of asset can be used to offset gains from another. For instance, losses booked by selling a stock can negate gains realized from the sale of a bond fund, or even a real estate holding. If your losses are larger than the gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income. If an investor doesn’t have $3,000 of taxable capital gains in a given year, the balance of the excess can be applied to ordinary income.1 It gets even better: Unused losses can be carried forward throughout the seller’s lifetime to offset future gains and can be transferred to a spouse upon death. Unfortunately, losses can’t be used to offset gains realized in prior years.
The Wash-Sale Rule
Tax-loss sellers must carefully adhere to IRS rules. Selling a holding and then promptly rebuying the investment, or a substantially identical one, isn’t permitted. Under the “wash-sale rule,” which is meant to keep investors from gaming the system, one can’t buy the same stock or exercise stock options 30 days before or after the sale from any investment account they own (including IRAs).
Naturally, the availability of a good replacement holding should be considered before selling.
The Limits of Tax-Loss Selling
Tax-loss harvesting is limited to transactions in taxable accounts. Selling holdings in a tax-advantaged account such as a 401(k) or IRA doesn’t create annual tax consequences, so realized losses in those vehicles can’t be used to cancel out gains in taxable accounts.
Long-term investors shouldn’t sell holdings just to minimize their tax pain—especially when the holdings they’re considering selling may only be experiencing temporary weakness. While it’s sometimes necessary to cut our losses on certain investments, achieving long-term goals, such as funding retirement, requires us to remain patient and disciplined. In other words, don’t let the tax tail wag the investing dog.
Consider Other Strategies
Keep in mind that tax-loss selling is just one tax-management strategy. Donating appreciated assets to charity, for instance, might yield greater tax savings. Donors typically don’t owe tax on the gifted assets’ gains, and the donation earns them a charitable deduction.
Why Life Expectancy Matters
On a very practical note, life expectancy should be factored into tax-management strategy. It might not make sense to harvest losses for use in future years since capital losses expire at death. What’s more, assets’ capital gains are no longer recognized for tax purposes after their owner is deceased, meaning they don’t need to be sheltered.
The Big Picture
Accumulating wealth isn’t just about what you earn—it’s about what you keep. And when it comes to keeping more, tax-management strategies like tax-loss harvesting can make a meaningful difference over time. Speak with your wealth advisor and tax professional to determine when or if this tax strategy makes sense for you.
1IRS: Topic No. 409 Capital Gains and Losses
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