Tax-Loss Harvesting: Turning Investment Lemons Into Lemonade

Key Takeaways

Sometimes, the markets hand us lemons. But even in an environment where both stocks and bonds are posting negative returns, there may be a sweet side for investors in the form of tax and portfolio benefits with tax-loss harvesting. The strategy can be a smart way to lower your tax liability while maintaining the appropriate investment mix in your portfolio.

Learn the ins and outs of tax-loss harvesting and the importance of using this strategy correctly. It’s always a good idea to consult a tax advisor for your particular situation, but being aware of general guidelines can help you take your lemons and make lemonade.

Let’s dig in.

How Tax-Loss Harvesting Could Reduce Your Taxes

Tax-loss harvesting is a year-round tax-mitigation strategy where you can sell investments to reduce current and future years’ capital gains taxes in your portfolio.

Here’s a hypothetical example of how it works. Let’s say Mary and Max bought two mutual funds years ago for $25,000 each.

Who Can Benefit From Tax-Loss Harvesting?

You don’t need to trade every day to benefit from tax-loss harvesting. Investors pursuing buy-and-hold strategies with minimal trading, and even those in retirement, may find it valuable. And current capital gains are not required.

Who Can Benefit

Investors with capital gains, which can come from a variety of sources:

• Rebalancing portfolios.

• Reducing large positions.

• Liquidating investments for income.

• Receiving capital gains distributions from actively managed mutual funds.

Note: Flows into and out of mutual funds are transacted in cash. The manager often must sell portfolio securities to accommodate shareholder redemptions or to reallocate assets. These sales may create capital gains for all fund shareholders, not just the ones selling their shares. These gains are taxable for all fund shareholders if held within taxable accounts.

Investors with no current-year capital gains to report:

• You can still harvest losses to lower your ordinary income by up to $3,000 per year ($1,500 if married and filing separately). Any excess losses above the yearly limits can be carried over for use in future years, without expiration.

Investments To Consider Selling

Individual stocks, bonds, mutual funds and exchange-traded funds (ETFs) are all potential candidates for tax-loss harvesting. Consider selling:

1. Investments that haven’t met your expectations.

Sometimes your initial reasons, or thesis, for holding an investment do not pan out. It can be tricky to sell because investors are susceptible to the "sunk-cost fallacy ," which is the idea that because you’ve already incurred costs, you must stick with the investment until you “get your money back.” This can lead to holding on to losing positions for way too long. You can reframe your thinking by asking yourself, “If I didn’t own this, would I buy it today?” If the answer is no, this may be a good candidate to sell and put your money to better use.

2. Investments that have grown to become large, concentrated positions.

Letting your winners run too long can lead to a lopsided portfolio. This increases the risk that your fortunes rise and fall based on the performance of one security or asset class. Tax-loss harvesting can help you rebalance your portfolio. Suppose your portfolio has drifted to 75% equities and 25% bonds from its original target of 60% equities and 40% bonds. In that case, you could sell losing equity investments and buy bond investments until you’re back to your original target investment mix—putting you back on track while lowering your tax bill.

3. Investments that have similar exposure in a tax-efficient alternative.

Both ETFs and mutual funds are subject to taxes on the difference between market value and cost basis when they are sold. They also are subject to taxes on capital gains distributions and income incurred while shares are held. But generally, ETFs are more tax efficient than traditional mutual funds because an ETF is bought and sold from one investor to another on an exchange as an in-kind trade. That means ownership of the ETF changes hands without directly selling the underlying stocks or other securities. This type of transaction, along with the mechanics of how ETF shares are issued and redeemed, typically results in fewer capital gains. Thus, ETFs could keep a larger pool of assets invested compared to mutual funds—which may mean more money that potentially earns returns and benefits from the power of compounding.

Still, you need to consider if a replacement security would not be deemed substantially identical by the IRS to avoid violating the wash-sale rule (discussed below).

Avoid These Harvesting Pitfalls

While a tax-loss harvesting strategy can be effective, there are several costly mistakes you should be aware of, including:

Wash-Sale Rule

The IRS’ wash-sale rule is a tax rule that prohibits investors from creating “artificial losses” by selling securities at a loss and buying the same or a substantially identical security within 30 days before or after the sale (a total of 60 days).

If you violate this rule, the IRS will disallow the loss, and you’ll end up paying taxes on gains that you thought were offset. Although the losses may not be “lost forever” and added back to the basis of the new securities purchased, it may defeat the purpose of harvesting the loss. Some factors to consider when deciding on a replacement investment that would not violate the wash-sale rule would be the degree of holdings overlap and the difference in prospective returns.

Investments in Tax-Advantaged Accounts

Tax-loss harvesting can be a valuable strategy for taxable accounts, but it’s important to avoid harvesting losses in tax-advantaged accounts like individual retirement accounts (IRAs), 401(k)s and 529s. In addition, you should avoid buying replacement investments inside the tax-advantaged accounts.

If you bought back the same investment or a substantially identical one in an IRA account, for example, the tax loss is lost forever. Stick with taxable accounts when using tax-loss harvesting. In the same vein, avoid related-party rules, where one spouse sells a security at a loss and buys the same security back in a spouse’s taxable account.

Don’t Let Taxes Drive Your Investing Decisions

While taxes are an important consideration when investing, and we hear about tax-loss harvesting causing the "January effect" in markets each year, taxes should not be the sole driver of investment decisions. Avoid making rash investment decisions based solely on tax considerations, as this can lead to poor performance or cause your portfolio to become loaded with massive, embedded gains and an outsized tax bill down the road. Finally, you could stray from your investment plan.

When used wisely, tax-loss harvesting can be a powerful tool to remain in control over your tax situation and potentially keep more money working for your future.