As your income has increased throughout the years, you’ve found yourself bumped up into higher and higher tax brackets. At this point, it becomes critically important to use every (legal) tool in your toolbox to reduce your taxable income.
When you track your performance based on your investment statement alone, you aren’t seeing your after-tax returns. This “net-net” bottom line figure is a significant metric in determining the effectiveness of your overall financial strategy.
Here’s where tax loss harvesting comes in – a wealth management approach that aims to efficiently manage your portfolio while benefiting from naturally occurring market volatility.
In this article, we will discuss tax loss harvesting, the practice of selling securities at a loss to offset gains elsewhere in order to maintain your market exposure and boost your tax efficiency. We’ll also dive into the pros and cons of tax loss harvesting, including the benefits of working with a volatile market; portfolio growth through reinvestment; and the potential for compounded returns. Finally, we’ll take a stroll through the risks of the wash sale rule so you can assess if tax loss harvesting aligns with your unique financial circumstances.
Getting Started with Tax Loss Harvesting
What is tax loss harvesting?
Tax loss harvesting is strategically selling investments at a loss in order to counterbalance gains from other investments in your portfolio.
By reinvesting the proceeds of a security in a similar asset, you’re able to maintain your market exposure year-round and keep your portfolio as tax efficient as possible.
What are the benefits of tax loss harvesting?
The primary goal of tax loss harvesting is to reduce your overall tax liability when losses are used to offset capital gains.
Thoughtful reinvesting of your tax savings can generate significant compounded benefits over time.
During market downturns, strategic tax loss harvesting allows you to capture losses that can be exercised against future gains.
What are the risks of tax loss harvesting?
If you buy the same security or a substantially identical one within 30 days before or after selling the loss-generating investment, you would lose the benefit of the tax loss by violating the wash sale rule.
The wash sale rule is a provision set in place by the IRS to limit the abuse of this tax saving strategy.
Who benefits from tax loss harvesting?
For those with a high net worth, tax loss harvesting can help rebalance your portfolio during market fluctuations, reduce your adjusted gross income in order to stay in a lower tax bracket, and manage taxes on substantial assets if you’re approaching retirement.
What Is Tax Loss Harvesting?
Tax loss harvesting is the strategic selling of securities at a loss to offset gains from other investments. The basic concept is simple: by selling investments at a loss, you can counterbalance gains in your portfolio. After selling your security, you immediately reinvest the proceeds in a similar asset, ensuring your portfolio remains invested, diversified, and aligned with your financial goals. This strategy has the ability to maintain your market exposure and keep your portfolio as tax-efficient as possible.
Tax loss harvesting is different from attempting to time the market or making impulsive decisions to try and cut losses. It opens up the potential for increasing returns over the long term, provided it is thoughtfully executed and takes into consideration your specific financial circumstances.
Benefits Of Tax Loss Harvesting
- Tax Savings: The primary advantage of tax loss harvesting is its potential to reduce your current tax liability. When filing income taxes, losses can be used to offset capital gains, lowering the overall amount owed. If gains are absent in the same tax year, you can carry forward losses to future years, providing a valuable tool for long-term tax planning.
- Grow Your Portfolio: Reinvesting your tax savings by employing this strategy can generate significant compounded benefits over the life of your investments. By thoughtfully reinvesting, you have the opportunity to accelerate the growth of your portfolio and watch your profits increase over time.
- Turn Uncertainty into Opportunity: Every challenge comes with an opportunity and market volatility is no different. You certainly can’t control ups and downs in the market, but you can manage costs and taxes efficiently and strategically. By implementing this strategy during market downturns, you place yourself in a position to capture losses that can be exercised against future gains.
- Reduce Risk: Tax loss harvesting offers a unique opportunity to sell high-risk or high-cost assets while potentially tempering a significant tax bill. This flexibility allows you to make strategic decisions regarding assets with unfavorable risk or cost profiles, aligning your portfolio with your risk tolerance and financial goals.
Risks Of Tax Loss Harvesting: The Wash Sale Rule
As you can imagine, we are not the only people to have stumbled upon this effective strategy. The IRS is also aware of this practice and has put a rule in place to limit the abuse of it. The wash sale rule is an IRS provision designed to make sure you can’t sell an investment to capture the loss and then immediately turn around and buy it back. This rule applies to a wide range of investments, including stocks, bonds, mutual funds, ETFs, and options.
Specifically, if you buy the same security or a substantially identical one within 30 days before or after selling the loss-generating investment, you would lose the benefit of the tax loss. The IRS also considers transactions between spouses within the restricted time period as wash sales
The key to the wash sale rule is the term “substantially identical security.” That means the securities in question are not different enough to be considered separate investments. Substantially identical securities refer to convertible securities and securities issued by a corporation that has undergone reorganization.
Securities issued by separate corporations, however, are not considered substantially identical. For example, you could sell General Motors and buy Ford, maintaining market exposure and a similar theme in your portfolio without triggering the wash sale rule.
Is Tax Loss Harvesting Right For You?
Determining whether tax loss harvesting will be a valuable tool for you depends on your specific financial situation. With your high net worth, consider the following scenarios where this strategy may be particularly beneficial to you.
- Significant Assets and Retirement Planning: When you have substantial assets or if you’re nearing retirement, tax loss harvesting can be a valuable strategy to offset gains and strategically manage taxes, especially when dealing with concentrated stock positions or planning for Net Unrealized Appreciation (NUA).
- Converting Traditional Retirement Accounts to Roth: If you’re thinking about converting funds from traditional retirement accounts to Roth during a market downturn, tax loss harvesting can be a smart idea. It helps offset gains, potentially reducing taxes on the conversion. This is especially beneficial if you’re a younger investor with a longer time horizon for Roth growth.
- Rebalancing in Market Fluctuations: During market twists and turns, using tax loss harvesting for strategic portfolio rebalancing minimizes capital gains and optimizes your overall mix of investments.
- Staying in a Lower Tax Bracket: If you’re close to moving into a higher tax bracket, employing tax loss harvesting helps lower your adjusted gross income, allowing you to stay within a more favorable tax bracket and potentially unlocking additional deductions or contributions.
The Bottom Line
Tax loss harvesting is a potent tool to optimize your portfolio and minimize current tax exposure. Selling securities strategically during market downturns not only offsets gains, but positions you for future opportunities. Beyond tax savings, it offers potential portfolio growth, and informed decision-making aligned with your financial goals and financial plan.
Final Thoughts
The longer a portfolio remains invested, the more time it can grow and compound. An approach you can take is repeating tax loss harvesting systematically throughout the year. You can miss some, if not all, of the potential tax loss harvesting opportunities by waiting until the end of the year. When tax loss harvesting is repeated in a systematic way, it can reduce your tax bill through tax deferral. Not only will you save on your taxes each year, you can reinvest those savings for potential growth in the future.
As market dynamics evolve and regulations continue to shape the economic environment, be sure to stay informed and collaborate with seasoned financial planners and tax professionals to maximize the benefits of tax loss harvesting and ensure compliance with IRS regulations.
At SK Wealth, our committed financial planners specialize in guiding individuals and business owners through strategic decisions on retirement plan implementation and its impact on their enterprises. Over the past 25 years, we’ve honed The Integrated Financial Advantage™, a distinctive financial planning process designed to offer clients personalized advice, empowering them to live with intention, both tomorrow and today.
