It’s a Harvest, Tax Loss Harvest That is!

It’s a Harvest, Tax Loss Harvest That is!

The other week I talked about the impact of tax strategies, specifically as it pertains to asset location, on your investments. Today, I am going to expand on that conversation by introducing a different tax savings concept on your investment portfolio in the form of tax loss harvesting.

What is Tax Loss Harvesting?

Essentially, tax loss harvesting is a way to minimize taxes owed on a portfolio by minimizing the taxes owed each year. You see, a typical non-retirement investment portfolio gets issued a 1099 each year which must be reported for taxes.  This nifty form spells out all the income, capital gains, and capital losses incurred each year on your investments. As you can imagine the larger the portfolio gets and the higher your income becomes, this can add up to a decent little extra tax obligation each year. 

Thus, the concept of tax loss harvesting is to find ways to minimize or mitigate this inter-year. This can be done by lessening the income generated in a portfolio or by finding a way to minimize capital gains, especially in the short term, throughout the year. As I talked about the other week with asset location, one simple way is to segregate those higher-income paying assets into tax-sheltered accounts like IRAs or 401(k)s. The other advanced management tool, however, is finding ways to minimize the capital gains owed each year.

As a refresher, you incur capital gains/losses only when you sell an asset. Thus, if you hold a stock let’s say and it appreciates over the years there is no tax owed on this holding. It is only when that stock gain is realized, or sold and turned into cash, that it is deemed a capital gain or loss. 

For instance, if I had a share of Apple stock, I bought it at $10 5 years ago and it is worth $150 today I owe nothing currently. However, if I sell that stock today, I will incur a $140 capital gain event in which I will owe taxes on it. If I am in a high tax bracket I will also get hit with an additional higher rate.

So How Does Tax Loss Harvesting Work?

The concept is rather easy, although the execution is very difficult. In tax loss harvesting, there are a few ways you can deploy this strategy to minimize your capital gains exposure. For starters, let’s say you have Apple stock from before that has incurred a $140 gain over X period. If wanting to get out of this holding, for whatever reason, a good tax loss harvester would say let’s sell Apple at the $140 gain. In addition, utilizing tax loss harvesting one would find a holding or holdings that have accumulated a similar type of loss and look to sell that stock at the same time. Effectively leaving you with a $140 gain and a $140 loss, meaning 0 net capital gains to report at year-end.

Since you can pair gains with losses it effectively is a way to get out of large gains by selling losers to offset your tax liability. What happens if you have more losses than gains?  In this scenario, there are two things that can happen. Your first $3,000 of net losses can be added to your tax bill each year to lower your taxes. If you happen to have more than $3,000 in losses, you don’t lose those losses per se. Instead, you can carry them forward to either use $3,000 more in losses in future years and/or use them to offset future capital gains you may incur.

This leads to a second tax loss harvesting strategy in forcing losses. For instance, if the stock market has a sudden dip, we can sell a holding to realize a loss. Then we can immediately buy a very similar type of holding, to avoid the 30-day wash rule, and lock in those losses to be used to offset future gains. Remember, since you don’t lose the losses, this can be a very effective strategy to have these losses at your disposal. 

In real life, the strategy could look like this. Markets dip and you have an X loss in your Schwab S&P 500 index ETF. We can force that sale, and then immediately buy the Fidelity 500 index, which is virtually the same thing. The net position is virtually identical however you have the losses now to work with as you continually manage a portfolio most effectively for taxes.

The Good & The Bad!

The bad thing with all this is, unlike tax location, this is a very nuanced and advanced strategy to deploy. It takes technology, research, software, and a lot of investment acumen. The good news is we employ some of the best investment brains in the industry who are extremely capable of doing this and a whole lot more for our client’s investment portfolios.

Hope you enjoyed this little trip down the tax savings lane.  As always stay wealthy, healthy, and happy!