By Mike Collopy, CFP®, CIMA®
Many investors have found themselves taking some serious losses because of the volatility in the stock market these last two years. If you are lucky (or savvy) enough to have realized capital gains, you now have to worry about the money you owe Uncle Sam. Realizing large capital gains can lead to a pretty hefty tax burden, especially if those gains are considered “short term.” If you held the investment for less than a year, your gains are taxed at your ordinary income rate, which can reach a maximum of 37%. (1) Luckily, you can lower your tax burden and make the most of an investment by using tax-loss harvesting.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is the strategy of selling investments at a loss in order to offset the gains in your portfolio. By realizing a capital loss, you are able to counterbalance the taxes owed on capital gains. The investments that are sold are usually replaced by similar securities in order to maintain the desired asset allocation and expected return.
Why Should You Use Tax-Loss Harvesting?
There is an upside to having an investment loss. Not only can it be used to reduce your tax liability, but it also helps to boost the overall rate of return for your portfolio. Here’s how it works.
Imagine you had an investment worth $5,000 at the beginning of the year that increased to $5,500 by December. This represents a pre-tax return of 10%, or 6.3% after taxes (based on a 37% tax rate).
Now imagine that same investment decreased to $4,500 in June and you decided to use the tax-loss harvesting strategy instead of holding it through December. You would have realized a $500 capital loss which could be used to offset taxes on gains or even taxable income. If you’re in the highest tax bracket of 37%, that means you would save $500 x 37% = $185 in taxes, adding a 3.7% return to your original $5,000 investment. If you also used the proceeds from selling your loss to purchase additional shares of a similar stock that also gained by December, then your net after-tax return on your investment would be 6.8% + 3.7% = 10.5%.
It may seem complicated, but tax-loss harvesting actually works to increase your overall returns by leveraging losses to work in your favor.
Tax-loss harvesting can only be used in taxable investment accounts, which means tax advantaged accounts like traditional IRAs, 401(k)s, and 403(b)s are off limits for this strategy. There are also other limitations to be aware of as you consider whether tax-loss harvesting makes sense for you.
- Wash sale rule. The IRS prohibits tax deductions if an investor sells a security at a loss and then purchases the same or “substantially similar” security within 30 days. (2) This is an important limitation to keep in mind, as investors often replace losses with similar securities in order to maintain a specific asset allocation. A way around this rule is to purchase a mutual fund or ETF that targets the same sector as the stock you sold.
- Tax liability limit. Harvested losses are used to offset capital gains first. If the amount of the loss exceeds the amount of your gain, then up to $3,000 can be used to offset other taxable income. Anything beyond $3,000 must be carried over to the following tax year. (3)
- Administrative costs. Making a sale every time your portfolio experiences a loss can be costly, both in time and administrative transaction fees. Keep this in mind as you look at your portfolio. Tax-loss harvesting should only be used if the reduction in taxes outweighs the increased administrative cost.
In light of these limitations, tax-loss harvesting makes the most sense for actively managed investments. At Veracity Capital, investment management is our speciality.
Learn More About Your Options
If you have large losses sitting in your portfolio and want to learn more about how tax-loss harvesting can work in your favor, reach out to us today. We have the tools and expertise to actively manage your accounts, ensuring you get the most value out of every investment transaction. Take the first step toward minimizing your tax liability by scheduling a complimentary introductory call by reaching out to me at 678-685-3265 or firstname.lastname@example.org.
Mike Collopy is wealth advisor and partner at Veracity Capital. As a fiduciary who puts his clients’ interests first, always, Mike is known for providing a holistic perspective on his clients’ finances. His comprehensive process first looks at the big picture of each client’s family, health, and wealth, then drills down to provide solutions for their financial needs, concerns, and goals. He’s passionate about the science of financial planning and investing and uses that to help his clients build a strong foundation for their financial life. Mike serves career-driven individuals who need professional advice to manage their wealth and maximize their opportunities, such as corporate benefits and complicated compensation packages. He considers his clients to be like family, and strives to support them and their families as they work hard for their financial future.
Mike has a bachelor’s degree in finance from Coastal Carolina University and an MBA from The College of Saint Rose. He is a CERTIFIED FINANCIAL PLANNER™ practitioner and is a Certified Investment Management Analyst ®. When he’s not working, you can find Mike spending time with his wife and young son, often exploring the great outdoors by hiking or enjoying the beach. He likes to stay active, playing basketball and training for half marathons. Mike gives back to the community by supporting organizations dedicated to finding treatments for cystic fibrosis. To learn more about Mike, connect with him on LinkedIn.