Tax-loss harvesting is a strategy used to produce tax savings where an investment that has declined in value is sold at a loss, and a similar investment is purchased simultaneously to maintain the portfolio’s investment mix – risk and expected return. To use the loss for tax purposes, i.e., avoid a wash sale, there is a waiting period of at least 30 days before the original investment can be repurchased. Since buys and sells in retirement accounts are not taxable, tax-loss harvesting is implemented in non-retirement accounts.
The losses realized through tax-loss harvesting can be used to reduce an investor’s taxes in the following scenarios:
- Offset capital gains produced from the partial or complete sale of an investment
- Offset mutual fund capital gain distributions
- Reduce ordinary income by up to $3,000
Long-term capital gains are taxable to investors at the 0%, 15% or 20% rate, based on their taxable income and marginal tax bracket. High income individuals may also be subject to the 3.8% Medicare surtax that applies to the lesser of their net investment income or the excess of their modified adjusted gross income above $200,000 if single or $250,000 if married filing jointly. These rates even if subject to the Medicare surtax are preferential compared to ordinary income tax rates, and any losses not used can be carried forward for the rest of the investor’s life.
The following example demonstrates the real life benefits of tax loss harvesting, applied to three scenarios.
At the beginning of year 1, an investor put $50,000 into a US small cap stock mutual fund and sold it for $100,000 at the end of year 5. Upon the sale, the investor realizes a $50,000 long-term capital gain. For our example, the investor is in the 32% marginal tax bracket and will be subject to a 15% long-term capital gains tax rate plus the 3.8% Medicare surtax, resulting in $9,400 in taxes. This will leave $90,600 for reinvestment into the portfolio or other purposes.
However, during that five-year period, we know the value of an investment in the stock market, especially in small cap stocks, does not rise in a straight line. Instead, the investment could increase or decrease by 10% or more in any given year. This equity volatility is the price we pay for the opportunity to earn returns that are much higher over the long-term than those paid by bonds or cash.
After considering the impact of equity volatility, let’s say that in year 2 the value of the investment decreases from $55,000 to $40,000 due to a market correction. This investment now has a $10,000 unrealized loss from the $50,000 original investment. If tax-loss harvesting is implemented, this investment is sold to take the loss and another fund providing similar exposure to US small cap stocks is purchased. During the next 30 or more days, if US small cap stocks increase or decrease in value, the portfolio will incur similar gains or losses as if the original mutual fund was never sold. Once the waiting period is over, the temporary placeholder US small cap stock fund is sold and the proceeds are used to repurchase the original mutual fund intended for long-term investment.
Keep in mind that tax-loss harvesting creates a loss now, but it also reduces your cost basis, which in this example leads to a $10,000 larger capital gain when the security is sold at the end of year 5. However, if $10,000 in realized losses isn’t used to offset any gains or income during the period permitting the losses to be carried forward, the investor would end up with the same $50,000 net capital gain. If the owner passes away before selling the investment, a gain wouldn’t be realized at all as their heirs would receive a step-up in basis.
Now let’s apply the $10,000 in realized losses to the tax benefits it creates in each of the three scenarios.
Scenario 1: Offset capital gains produced from the sale of an investment
Whether it’s done to cover withdrawals or rebalance the portfolio back to its original asset mix, the sale of an investment for a profit will result in a capital gain.
Let’s say that to rebalance the portfolio’s investment mix between stocks and bonds, a $10,000 long-term capital gain is realized. This could result from a partial or full sale of a fund. The $10,000 loss realized earlier from the US Small Cap Stock fund can be used to offset this capital gain, resulting in $0 capital gains taxes owed. More importantly, this allowed the portfolio’s risk and expected return to be adjusted back to targets without adverse tax consequences.
Scenario 2: Offset mutual fund capital gain distributions
In mid-to-late December, mutual funds that sold securities within their fund during the year at a profit will make capital gains distributions to investors. In this case, the investor did not execute any transactions or have any control of this distribution.
Since capital gains distributions from mutual funds are taxable to the investor just like any other capital gain, the investor can use their realized losses from earlier to offset part or all of these distributions. For example, if an investor had a large position in a mutual fund and received a $10,000 long-term capital gain distribution at year-end, the $10,000 realized loss could eliminate that gain, turning what could have been an additional $1,880 ($10,000 X (15% capital gains tax + 3.8% Medicare surtax)) tax bill to zero.
Scenario 3: Reduce ordinary income by up to $3,000
In the event the investor doesn’t have any or enough capital gains to offset, realized losses can be used to reduce up to $3,000 in ordinary income each year. Since this example’s investor is in the 32% marginal tax bracket, reducing ordinary income by $3,000 in years 2, 3 and 4 would result in tax savings each year of $9600, or $2,880 total with $1,000 remaining in loss carryforward. This leads to a net $1,188 [$2,880 – (($10,000 capital gain – $1,000 remaining loss carryforward) * (15% capital gains tax rate + 3.8% Medicare surtax)] in tax savings from using loss carryforward to reduce ordinary income when compared to paying capital gains taxes on that same $10,000.
Since investors own several stock funds in their portfolios, this tax-loss harvesting strategy can be implemented several times over to yield significant tax savings over an investor’s lifetime.