December 2022 is capping off a poor year for investors worldwide. With stocks and bonds falling in tandem thanks to high inflation and rising interest rates, even investors holding balanced portfolios suffered higher-than-expected losses. Aside from some hedge funds and commodities, few assets stayed in the green.
Still, every situation has a silver lining, and the 2022 bear market is no different. For investors enduring unrealized losses, there’s a way to potentially offset future capital gains and even some of your income tax before the year is up. Your paper losses have a hidden upside.
The method is called tax-loss harvesting, and when implemented correctly it can save you money and boost your after-tax returns significantly. However, implementing a tax-loss harvesting strategy can be complex and fraught with legal considerations. Here’s what the experts have to say about it.
— What is tax-loss harvesting?
— When to tax-loss harvest.
— How to tax-loss harvest.
— Other tax-loss harvesting considerations.
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What Is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy “used in portfolio management to lower your tax bill for investments held in taxable brokerage accounts,” says Anessa Custovic, chief investment officer at Cardinal Retirement Planning.
“At its core, tax-loss harvesting involves selling assets at a loss and then using those capital losses to offset capital gains and taxable income,” Custovic says.
Investors who sell investments in a taxable account for a profit must pay capital gains tax, which can be in two forms, according to Taylor Sohns, co-founder of LifeGoal Investments. “If the gains are ‘short term,’ meaning the investment was bought and sold within 365 days, the investment gains are taxed at that individual’s ordinary income rate,” he says. “If the investment was held for more than 365 days, the gains are taxed at the ‘long-term’ capital gains rate, which is currently 15% for most, but can be up to 20% for high-income earners.”
By selling investments at a price lower than their cost basis, an investor can therefore “realize” that loss and use it to offset capital gains tax. According to Sohns, the harvested losses are applied to like gains, meaning long-term losses will first be applied to long-term gains, before being applied to short-term gains. “If an investor’s losses turn out to be greater than their gains, the tax code allows $3,000 a year to offset ordinary income on federal income tax, and any excess can be carried forward indefinitely,” Sohns says.
Jamie Ebersole, founder and CEO at Ebersole Financial LLC, notes that the main benefit of tax-loss harvesting is an improvement in the long-term performance of your portfolio by shielding taxes that would need to be paid from somewhere. “Because the losses are already baked into the portfolio, the selling does not reduce your portfolio value in any way,” he says.
When to Tax-Loss Harvest
According to Custovic, the time to tax-loss harvest is right now. “You should consider tax-loss harvesting because the last day of the trading year is Dec. 30,” Custovic says. “Any trades or attempts at tax-loss harvesting after that day will not affect your tax bill this year,” she says.
Austin Delery, partner at The Olivier Group, agrees, noting that “December is a critical time for all investors to review their portfolios for any taxable gains or losses that can be harvested.”
Tax-loss harvesting as soon as possible is always a good idea, Ebersole says. “In general, the current tax benefit is worth more to you this tax year rather than next due to the time value of money. Therefore, it’s generally better to take losses as soon as possible and harvest them,” he says.
This is especially important when it comes to short-term capital gains. According to Custovic, you should tax-loss harvest in this case since they will be taxed at a higher rate than long-term capital gains.
How to Tax-Loss Harvest
Chris Rivers, principal at Armstrong, Fleming & Moore, gives the following scenario as a hypothetical example of a tax-loss harvesting strategy:
Let’s say you sell a position at a $15,000 loss, and elsewhere in the portfolio you had gains of $4,000. That gain would be offset by the loss, leaving you with $0 in capital gains income.
To capture the loss and avoid the IRS’s wash-sale rule, an investor must remain out of that position for 31 days or purchase another security that is not “substantially identical.”
From there, you have $11,000 remaining in losses, from which you could then deduct $3,000 against your ordinary income. The remaining $8,000 can be carried forward for use in later years.
Delery emphasizes the importance of the $3,000 deduction against ordinary income. “Although $3,000 feels minute in grand scheme of things, the real advantage comes from the carry-forward rule of losses over that $3,000 limit, especially if your income is projected to grow,” he says.
Other Tax-Loss Harvesting Considerations
A big consideration investors should watch out for is the IRS’s wash-sale rule. This rule only allows investors to tax-loss harvest if they do not repurchase the same security or a substantially identical one within 31 days. While investors can remain in cash for that period, there is a way around it.
Rivers notes that the rule isn’t crystal clear. “The law was written into IRS code in 1921 before things like mutual funds and index funds existed, and the IRS has not laid out specific, concrete guidelines since that time. As usual, they leave a gray area for interpretation,” he says.
Darin Tuttle, founder and chief investment officer at Tuttle Ventures, adds that “when choosing to reinvest proceeds in a similar investment, tax practitioners generally agree that investors should consider the degree to which its holdings may overlap with the original investment, and the degree of difference in their prospective returns.”
As an example, Rivers notes that selling a large-cap mutual fund issued by Fidelity to harvest losses and then immediately repurchasing a large-cap mutual fund issued by T. Rowe Price is unlikely to run afoul of the rule. “In this case, they are run by different fund managers, have different underlying expenses, and different underlying holdings, even though they both buy large-cap U.S. stocks,” he says.
On the other hand, doing something like selling Berkshire Hathaway Inc. Class A (ticker: BRK.A) shares and then buying Berkshire Hathaway Class B (BRK.B) shares would likely violate the rule. “In this case, while there are some differences in the shares in terms of voting and stock price, they are still shares of the same company and thus are likely to be considered substantially identical,” Rivers says.
Tuttle recommends using exchange-traded funds, or ETFs, for avoiding the wash-sale rule due to their breadth. “Given the number of different ETFs available on the market, investors can easily find multiple tax-loss-harvesting pairs,” he says. He gives the example of Vanguard FTSE Developed Markets ETF (VEA), which can be tax-loss harvested against Schwab International Equity ETF (SCHF).
“According to Morningstar, there is an 82% overlap in the core holdings of each ETF, and both use a primary benchmark version of the FTSE Developed Market Ex-US Index,” Tuttle says.
“Because both ETFs have similar historical performance and low expense ratios, they are ideal for tax-loss harvesting against one another,” he says. Having multiple ETFs available can therefore help investors continually tax-loss harvest throughout a market downturn, lowering tax bills and boosting net returns.
So yes, it’s true that most investors will have to chalk 2022 up as some kind of a loss. But that’s not necessarily such a bad thing.
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Tax-Loss Harvesting: The Bright Side to 2022’s Sell-off originally appeared on usnews.com
