Tax-loss harvesting is an effective strategy to generate tax savings.
While this statement holds true in the short-term, if you take a step back and look at the long-term ramifications, the benefits—and drawbacks—of tax-loss harvesting are a bit more involved.
In this Insight, we’ll take a look at what tax-loss harvesting is and how it can be used to benefit investors. After that, we will go over some potential drawbacks that should be considered before implementing the strategy.
What is Tax-loss Harvesting?
Tax-loss harvesting is selling an investment at a loss in order to offset capital gains in the current year or in future years. By selling the investment at a loss and immediately purchasing a similar (but not identical) investment, you can lock in a tax loss without taking money out of the market. On the federal level, capital losses can be carried forward indefinitely.
While the concept of tax-loss harvesting seems like a no-brainer, there are a few caveats to keep in mind:
Let’s say that your emerging markets stock fund is down from when it was initially purchased. You might think that selling the fund now, locking in a loss, and buying back into the fund would allow you to recognize a tax loss. If that sounds too good to be true, you would be right.
Because of the wash-sale rule, purchasing the same or a “substantially similar” security within 30 days will result in the IRS no longer allowing that loss to count against your capital gains liability. The best way to avoid a wash-sale is to purchase a similar but not substantially similar security. Determining the difference between the two can be nebulous, so be sure to consult a financial advisor.
Long-Term Implications of Tax-Loss Harvesting
With tax-loss harvesting, it’s important to keep the long-term picture in mind. By its very nature, loss harvesting reduces the cost basis of your investments. This means that your tax loss will likely be “recaptured” in the future in the form of larger capital gains. While you will save money on taxes in the current year, you could end up with a larger tax liability down the road.
With that in mind, what are the benefits of tax-loss harvesting?
The Benefits of Tax-Loss Harvesting
While harvested losses will, in most cases, be exceeded by future realized gains, there is a quantifiable benefit—the deferral of taxes. The tax savings generated in the year of action allow you to continue investing money that, if not for the harvested losses, would be handed over to the federal government in the form of taxes.
As long as you’re able to defer the taxes—by not realizing taxable gains above and beyond the harvested losses—you can benefit from the return on money that would have otherwise gone toward your tax bill.
In addition to lowering your capital gains tax liability, harvested losses can also be used to offset up to $3,000 of ordinary income per year. Since ordinary income is generally taxed at higher rates than capital gains, this is a nice additional coup.
How do Changing Tax Rates Affect Loss Harvesting?
If you defer taxes by harvesting losses at your current capital gains rate and your rate becomes lower in the future, you’ve effectively created additional savings by timing the tax rates to your advantage.
Though, this could just as easily go the other way. If your capital gains rate increases in the future, you might have been better off holding onto your investment.
To illustrate, let’s take a look at three different investor scenarios:
Scenario #1: The High Earners
The high earners are a married couple living in New York City. They are both 60 years old and plan on retiring at age 62. They will earn around $750,000/year combined until they reach retirement. Based on income, their marginal capital gains tax rate is 34.53%*. But after retirement, that rate could drop down to 25.21%*. This is an ideal scenario for tax-loss harvesting.
The couple could benefit significantly by deferring taxes at 35% and paying them back at 25%.
Scenario #2: The Up-and-Comer
The up-and-comer is a 35-year-old single entrepreneur living in California. She’s making $200,000/year but expects to be making as much as $500,000/year within five years. Her marginal capital gains tax rate today is 24.30%*. In five years, it could be 35.10%*. This is may not be an ideal scenario for tax-loss harvesting. It is essentially the opposite of Scenario #1—deferring taxes today only to pay them back at a higher rate in the future. Depending on a variety of factors, the benefit of tax deferral may or may not outweigh this.
Scenario #3: The Generous Grandmother
For the final example, let’s consider a widowed, 90-year-old grandmother living in Virginia. Despite her sizeable net worth, she has frugal spending habits. She wishes to pass on the majority of her assets to her children and grandchildren. Her marginal capital gains tax rate is 20.75%*. This is a homerun scenario for tax-loss harvesting. She will increase her wealth by deferring taxes, and after she passes, her assets will receive a full step-up in cost basis.
Should You Utilize Tax-Loss Harvesting?
To recap, a tax-loss harvesting strategy is most effective if you:
- Expect your capital gains tax rate to stay the same,
- Expect your capital gains tax rate to go down, or
- Are an elderly investor with legacy goals and a limited need for your taxable assets.
With that in mind, it’s important to remember that tax-loss harvesting is not a one-size-fits-all approach. It should only be used after careful consideration of your time horizon, portfolio goals and future outlook. More importantly, it is a strategy that should be executed under the guidance and recommendation of a trusted financial advisor.
Interested in learning about how to add tax-loss harvesting to your financial playbook? Schedule a free investment consultation today.
*Tax rate sources and marginal capital gains rate calculations:
Sources- Federal capital gains tax rates and net investment income tax (NIIT). New York, California, and Virginia state income tax rates. New York City income tax rates.
Scenario #1 calculations
20% (federal) + 3.8% (NIIT) + 6.85% (NY state) + 3.876% (NYC) = 34.526%
15% (federal) + 6.33% (NY state) + 3.876% (NYC) = 25.206%
Scenario #2 calculations
15% (federal) + 9.3% (CA state) = 24.3%
20% (federal) + 3.8% (NIIT) + 11.3% (CA state) = 35.1%
Scenario #3 calculations
15% (federal) + 5.75% (VA state) = 20.75%