Tax-loss harvesting is a strategy you may be considering. But do you understand its rules, benefits, and potential risks? Let’s take a closer look at how tax-loss harvesting can benefit your investment portfolio, and how Dechtman Wealth Management can help you keep more of what you earn from your investments.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a tax reduction strategy that involves selling an investment for a loss in a non-retirement account. When you have losses in a non-retirement investment account, tax-loss harvesting is a way to both help with your taxes and rebalance your portfolio so you can make ongoing adjustments.
Tax-loss harvesting is the process of reviewing your aggregate losses and using them to offset the tax burden that may be brought on when you sell an investment for a gain.
When you hold an investment for over a year–12 months and one day, specifically–it’s considered a long-term investment. That investment can either be a long-term gain or a long-term loss, depending on performance. If you sell an investment within 12 months of purchase, it’s a short-term gain or loss.
At the end of the year, you net out short and long-term gains versus the losses. If there is anything leftover in the short-term loss bucket, tax-loss harvesting allows you to use up to $3,000 as a deduction against income that is taxed at your marginal income tax rate (e.g. your salary from work). From a tax perspective, this can be incredibly valuable because the tax rate on your income from work is likely much higher than the capital gains rate you would pay. That deduction could be substantial from a tax perspective.
What Are the Rules of Tax-Loss Harvesting?
As you can imagine, there are substantial tax-loss harvesting rules that one must follow, which is why you will benefit from the help of an experienced fiduciary financial advisor. One of the most important of these rules is known as a “wash sale rule.”
How does the wash sale rule apply to tax loss harvesting?
According to the IRS, “A wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale you:
- Buy substantially identical securities,
- Acquire substantially identical securities in a fully taxable trade, or
- Acquire a contract or option to buy substantially identical securities.”
The IRS expressly prohibits investors from deducting losses related to wash sales.
For tax-loss harvesting, what this means is that if you sell a 500 index fund from Company A, in a non-retirement account, at a loss, and buy a 500 index fund from Company B two weeks later, you cannot deduct the loss from the first sale. These would be considered “substantially identical.”
But there may be ways to work within the wash sale rule. CNBC explains “While you may run afoul of the rule for selling one index fund that tracks the S&P 500 and buying another one, you’d be fine investing in a fund tracking the Russell 1000 — another market index that tracks large-company U.S. stocks.”
It’s worth noting that rules and guidelines are complex and occasionally change. For example, cryptocurrencies are not necessarily subject to the wash sale rule, and you may be able to realize a loss immediately upon selling and rebuying the same asset. And here in this nuance is precisely where the guidance of a professional can be invaluable.
What is the penalty for violating the wash sale rule?
The primary penalty for violating the wash sale rule is that you will be legally prohibited from realizing the tax benefits from the losses to offset your gains. Investopedia says “The amount of the loss must be added to the purchase price of the security you bought that breached the wash-sale rule. According to the IRS, this postpones the loss deduction until the security is sold.”
What Are the Benefits of Tax-Loss Harvesting?
As we’ve discussed, there are real benefits to tax harvesting your losses. With this process, you can realize a significant tax break on your long-term capital gains. According to CNBC:
“If you sell an investment at a loss, you can use the loss to offset any gain you might otherwise owe tax on. At first, offsets must be like for like: Use short-term losses to offset short-term gains and long-term losses to offset long-term gains. Then, any excess losses can be used to offset the opposite kind of gain. If, after that, your losses still exceed your gains, you can use up to $3,000 of your net loss to negate ordinary taxable income.”
In addition to the tax savings and benefits, tax-loss harvesting is worth it because it can help you to rebalance your portfolio. If you sell an underperforming asset and then buy another that is similar, but not “substantially identical” (which would fall under wash sale rules), you can find new ways to meet your investment goals.
Are There Risks Involved with Task-Loss Harvesting?
A potential risk of tax-loss harvesting is that when you sell the security for a loss in a non-retirement account, you cannot buy that substantially identical security within 30 days. You run the risk that the security you have sold substantially rises within that 30-day span, causing you to miss out on that potential short-term capital gain.
Another potential risk is that, in some cases, there are transaction costs associated with buying or selling securities. It’s vital to understand the costs involved on either end of the transaction.
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