Tax-loss harvesting has the potential to boost your returns without adding risk. It’s not as complex as it sounds. We’ll walk through how it works, where it’s sensible to use it, and the benefits.
When you invest and your investments go up, then you often end up paying tax on the money you make once you sell. The key thing is that it doesn’t actually matter whether you investment has risen, what matters for tax purposes is when you sell it. You can control when you sell your investments. That’s what triggers the tax bill. That timing of the decision to sell is the key to how tax-loss harvesting works.
So, first of all, many investments are tax-sheltered, maybe you have an IRA, perhaps your investing in a 401(k). These are great, because the only thing better than minimizing your tax bill, is not having to pay tax at all, and in many cases the way IRAs and 401(k)s are set up mean you often don’t have to worry about taxes on your investment gains while you’re in the saving phase. However, if you have a standard investment account that is not tax sheltered, then taxes do come into play. For example, maybe you made 20% on your portfolio over the past 6 months. That’s great, but if you sold the investments to realize that gain, then depending on your tax bracket, what was a 20% gain, could fall to below 13% after taxes are paid, if you’re in the highest tax bracket, and state income taxes can matter too. Seeing a 20% return but only getting 13% once tax is paid is not ideal, and there are steps that you can take to improve the situation.
The first step, where possible is to consider IRAs, 401(k)s, 403(b)s and similar tax-sheltered ways to save. This can avoid certain taxes altogether, because that’s exactly why these schemes were created, to support American savers. Of course, there are drawbacks too, such as the money should be used for its intended purpose such as retirement, otherwise additional fees and taxes may apply. Nonetheless, if you’re saving for retirement and not using an IRA or 401(k) to do it, then you may be missing out and you should know your options there, before getting deep into the details of tax-loss harvesting.
Long-Term Capital Gains
Long-term capital gains matter too. Most investments see a lower rate of tax on the capital gain if held for more than a year, that can be a good thing. This is to encourage long term investing and it’s a valuable incentive. In that prior example where you sold after 6 months and your 20% came becomes 13% due to tax, well if you’d held on and sold that investment after 12 months, then you’d see a 16% after-tax gain rather than 13%. That’s quite a meaningful difference for just a few months of patience, and assuming the investment you’re seeing a gain on isn’t likely to see large swings in value. So remember, before we even get to tax-loss harvesting consider which tax-efficient saving options you have and whether you can sensibly wait at least a year before selling winning investments.
Now, if you still have savings in a taxable account, here’s where tax-loss harvesting can help you. If you have an investment that has lost money and, ideally have been held for under a year, then you can sell it and realize that loss. Remember, an investment typically only impacts your taxes once it is sold, and, if you’re a DIY investor, then you control when that sale happens. So by selling your losers, you are creating a taxable loss. That’s helpful, it can help reduce your tax bill either directly or by offsetting gains.
You may now be asking, why bother? Surely a loss is a loss whenever you take it. Yes, that’s perfectly true, but consider if you had a choice between writing a check for $1,000 today to the IRS or paying $1,000 in 2038. Though it may not seem like it at first glance, there’s a big difference between those two situations based on the time value of money. Let’s assume you can earn 7% a year on your money in the stock market. Remarkably if invested to consistently earn 7% a year, $1,000 would be worth almost $4,000 by 2038 due to the magic of compounding. Therefore, even though you’re paying $1,000 to the IRS in both cases, because you are paying the money 20 years later, in this hypothetical example, you can earn an extra $3,000 or so on the money just by delaying the payment. That’s, in essence what tax-loss harvesting does, you take your losses earlier, delay payment on the gains, and as a result you still pay a similar total tax bill, but you pay it later. The result is you can earn a return on the money you would have paid in tax as you keep it for longer. In essence, you delay paying your tax bill by making sure you realise your investment losses quickly, but your gains more slowly.
Students of behavioral investing may notice a hidden benefit here as well. Studies suggest that investors are often irrational in wanting to sell their winners too early and hold onto their losers, perhaps because of the presence of momentum in the stock market, this can be a poor strategy, at least for the shorter term. An effective tax-loss harvesting strategy has the benefit that it can reduce this behavioral bias that can end up costing many investors in potential returns.
The Catch – Wash Sales
However, it’s important to know that the IRS has rules designed to stop the most basic of tax-loss harvesting strategies. If you sell an investment and have bought or sold the same investment, or a substantially identical one in the window 30 days before or after the trade, that’s called a wash sale and the loss can be disallowed for tax purposes. Therefore, you must be careful when taking a loss, if you’re bought the same investment recently, or buy it back too soon, even in a different account, then that can be a problem and eliminate the benefit. If capital gains tax rates move up and down in future, for you based on your tax bracket or more generally based on the tax code, that impacts the effectiveness of the strategy too.
Historically, most tax-loss harvesting was done in December. That’s potentially better than no tax-loss harvesting at all, but it’s not ideal. First off, your greatest losses may occur be in December. For example, for this year so far, the bigger dips in the market came in February and October, those may have been better times to sell depending on your investment. Secondly the problem is that generally in the market following the same strategy as everyone else sometimes doesn’t work out so well. This could be the case with tax-loss harvesting in December. There is something called the January effect, where smaller stocks that have fallen in value the prior year tend to have good ‘bounce’ in January. Tax-loss harvesting may contribute to this phenomenon, and if you are tax-loss harvesting a stock, you may miss out on January gains because you need to be out of the stock because of the 30-day wash sale rule we’ve just discussed. That’s why tax-loss harvesting now, or basically any month other than December, can be a good idea. That way hopefully you’re back in the stocks you care about by January, having avoided the wash-sale constraint, in order to pick up any outsized gains.
So depending on how and where you invest, tax-loss harvesting may be a way to improve your after-tax returns. Learning the ropes once may help you for decades.