Tax-Loss Harvesting: Capital Gains and Reducing Your Taxes
- Erik James Roberts, Founder & Chief Investment Officer | Infinitus Wealth Management
- Dec 20, 2022
- 6 min read
It has been an extremely volatile year for the equity and fixed-income markets, as rising inflation, a series of large interest rate hikes, and fears of a recession continue to cause markets to tumble. If you're not a client of Infinitus Wealth Management, you might have your fair share of investment losses, but a tax-loss harvesting strategy will use your investment losses to offset your taxes while maintaining your market exposure.
Tax-loss Harvesting Explained
Tax-loss harvesting is a way to reduce your taxable income by selling investments at a loss to deduct those losses from your taxes. For example, deducting investment losses can offset all or some of the capital gains tax you owe on other profitable investments and may even reduce some of your taxes on your ordinary income.
The Benefits of Tax-Loss Harvesting
Tax-loss harvesting helps professional and retail investors reduce their taxes by offsetting the amount they have to claim as capital gains or income. For example, you "harvest" losing investments to sell at a loss, then use that investment loss to reduce or even wipe out the taxes you have to pay on investment gains you made during the year.
Investors who have yet to realize profitable investments can still use the losses to reduce taxes they will have to pay on their ordinary income.
Tax-Loss Harvesting Rules to Know
There are a few considerations to be aware of to stay compliant with the IRS:
Rules for Wash Sales: Your loss is prohibited if, within 30 calendar days of selling the investment, you or your spouse invests in something that is "substantially similar," as described by the IRS, to the one you recently sold.
Cost basis calculations: Most investors don't purchase their entire position in a mutual fund, stock, or ETF in a single purchase, so most likely, the price you paid for the investment varied by price and time. Good records of every purchase are required to come up with the correct cost basis to report to the IRS.
It might seem complicated, but you are not alone. Every investor should learn this strategy to reduce their taxable income.
How Tax-Loss Harvesting Works
Tax-loss harvesting will be beneficial if the investments are held in taxable brokerage accounts.
The concept behind tax-loss harvesting is to offset taxable investment gains. Because you are not taxed on capital gains in qualified accounts, such as 401(k)s, 403(b)s, IRAs, and 529s, there is no reason to use tax-loss harvesting to reduce your taxes.
It is less financially beneficial if you are in a low-tax bracket.
Since the reasoning behind tax-loss harvesting is to lower your tax bill today, it is most beneficial for people currently in the higher marginal tax brackets. That is because the higher your income tax bracket, the more significant your savings.
If you are currently in a lower marginal tax bracket and expect to be bumped up to a higher marginal tax bracket in the future because of a pay raise, or if you believe the government will raise tax rates in the future, You should save the tax harvesting until later when you will reap more savings from the strategy.
You must enact your tax-loss strategy by Dec. 31
The IRS gives some leeway to opening and funding an IRA until the tax-filing deadline. There is no such leeway for tax-loss harvesting.
You must complete your harvesting before the end of the calendar year, Dec. 31. So don't procrastinate.
Tax-loss harvesting is most useful if you invest in individual stocks, actively managed funds, or exchange-traded funds.
Index fund investors typically need help to employ tax-loss harvesting in their portfolios. However, it is different if you index using ETFs or mutual funds targeting a specific niche.
You must keep your long-term capital gains and your short-term capital gains separate.
The taxes you pay on capital gains are based on the length of time you have owned that particular investment.
IRS holding-period rules:
Short-term capital gains tax rates are applied when investors sell something they have held for a year or less. Short-term capital gains are taxed at a higher rate and as ordinary income, based on your marginal tax rate.
Long-term capital gains tax rates are generally lower than your short-term capital gains rates and are applied when you sell an investment that you have held for longer than a year. The IRS rewards you for holding investments longer by taxing you the lower 0%, 15%, or 20% on your gains, depending on your tax bracket.
Strategically Harvest Losses to Increase Your Tax Savings
When looking for potential tax-loss selling possibilities, consider investments that don't fit your strategy, have poor potential for future growth, or can be easily replaced by similar investments that fill the same role in your portfolio.
Focusing on short-term losses provides the most significant benefit when looking for tax losses because they are taxed at a higher marginal rate and used first to offset short-term gains.
According to the IRS tax code, short-term and long-term investment losses must be used first to offset gains of the same type. For example, if your losses of one kind exceed your investment gains of the same type, you can apply the excess losses to the other type of capital gain.
If you have harvested short-term investment losses but have only unrealized long-term gains, consider realizing those investment gains in the future. The least effective use of harvested short-term investment losses would be to apply them to the lower-taxed long-term capital gains. However, paying the long-term capital gains tax may still be better based on your specific circumstances.
Also, remember that realizing a capital loss can be useful even if you didn't realize capital gains because of the capital loss tax deduction and carryover provisions. For example, the tax code allows joint, single, and head-of-household filers to apply up to $3,000 yearly in capital losses after offsetting investment gains to lower ordinary income, which is taxed at a higher marginal rate.
If you still have capital losses even after applying them to capital gains and then to ordinary income, the IRS allows you to carry them forward for future years.
Make Tax-Loss Harvesting Part of Your Annual Tax and Investing Strategy
The best way to maximize the potential of tax-loss harvesting is to incorporate it into your annual tax planning and investing strategy.
Portfolio rebalancing and tax-loss harvesting are used in tandem to achieve your investment goals. Tax-loss harvesting and frequent rebalancing keeps your portfolio aligned with your investment goals, and regular rebalancing creates an opportunity to reexamine suboptimal investments that could be potential candidates for tax-loss harvesting.
Stay Consistent With Your Investment Goals
Keep taxes from changing your entire investment strategy. If you decide to implement tax-loss harvesting, ensure your goals are aligned. Ultimately, a balanced investment strategy and frequent assessment to confirm that your investments are aligned with your objectives is the intelligent approach.
If you're considering implementing a tax-loss harvesting strategy but don't have the knowledge, will, or time to do it yourself, an Infinitus Wealth Management advisor can help.
At Infinitus Wealth Management, we offer a complimentary, no-obligation portfolio review for investors who want an independent fiduciary second opinion on how their capital is actually being managed.This is a conversation, not a sales process. If your portfolio is already well constructed, we will say so directly. If we identify avoidable costs, unnecessary concentration, tax inefficiencies, or portfolio structure that may be working against you, we will show you specifically where those issues exist. From there, you decide what to do with the information.
Important Disclosures
Infinitus Wealth Management is a registered investment advisory firm. This article is provided for educational and informational purposes only and does not constitute investment, tax, legal, or accounting advice. It is not an offer or solicitation to buy or sell any security or to enter into any advisory relationship. Any references to specific strategies, withdrawal rates, tax provisions, or historical figures are general in nature and may not be appropriate for any individual investor.
Past performance is not indicative of future results. All investing involves risk, including the possible loss of principal. Tax laws are complex, change frequently, and have unique application to individual circumstances; please consult a qualified tax professional regarding your specific situation. Social Security rules, Medicare rules, and retirement account regulations are subject to legislative and regulatory change.
The information in this article was believed to be accurate at the time of writing but is not guaranteed. Readers should consult with their own qualified advisors before making any financial decisions specific to their situation.
