Syndicated advice columnist Ann Landers once quipped, “A person doesn’t know how much he has to be thankful for until he has to pay taxes on it.” For the nearly 60% of Americans who currently pay income taxes to the federal government, according to Statista, that’s a shared understanding. In fact, as of July 31, the U.S. Treasury Department has collected $1.83 trillion in tax revenue, or just short of 50% of its projected revenue, from individual income taxpayers this year.
The rub is 6 in 10 Americans say they pay too much in federal income taxes, according to a 2023 Gallup poll. Only 36% of Americans say their federal income taxes are “about right.”
Related: Sign up for stock news with our Invested newsletter.
As such, savvy investors are curious about cohesive strategies that can potentially help them curb their federal taxes and improve their financial outcomes over time. A tax-loss harvesting strategy fits that bill:
— How tax-loss harvesting works.
— What is the wash-sale rule in tax-loss harvesting?
— 3 tax-loss harvesting terms to know.
— How much does tax-loss harvesting save investors?
How Tax-Loss Harvesting Works
A loss on a stock, bond, mutual fund or other investment must be “realized” before it can be claimed for taxes. That means the holding must be sold. Here are the key steps to harvesting a loss for tax purposes:
— An investor sells an underperforming investment, like an exchange-traded fund or individual stock, in a taxable investment account.
— Any realized loss can be used to reduce realized capital gains and potentially offset up to $3,000 in ordinary income.
— The deadline for realized, reportable gains and losses is Dec. 31 of each year.
— An investor can reinvest the proceeds into a different investment that is better aligned with his or her financial objectives.
As with any investment strategy, though, there are some important guardrails to keep in mind along the way:
What Is the Wash-Sale Rule in Tax-Loss Harvesting?
Rob Kuharic, a chartered financial analyst and director of tax-managed solutions for Russell Investments, says the “main thing to watch out for when tax-loss harvesting is the IRS wash-sale rule.” Publication 550 says that when you sell a security or “substantially identical” equivalent for a loss, you can’t buy it back for 30 days nor could you have bought it 30 days prior to the sale date.
“The wash-sale rule is, in essence, to keep investors from abusing this tax benefit,” says Kuharic. “If you do trigger a wash sale, you basically lose the ability to use the loss as a tax asset.”
3 Tax-Loss Harvesting Terms to Know
Opportunity cost. Opportunity cost, or the cost of keeping your cash proceeds on the sidelines too long, is another key principle to keep in mind. “When implementing tax-loss harvesting, it’s important to give nearly equal consideration to what you reinvest the trade proceeds into,” says Kuharic.
Tax alpha. When investors take a deeper dive into tax-loss harvesting strategies, they’ll also likely encounter industry jargon such as “tax alpha” and “tax savings.” Tax alpha is simply the “difference in investment performance between a client’s portfolio that utilizes a tax strategy versus its benchmark,” says Hiren Patel, head of advisor solutions at fintech firm 55ip.
Tax alpha involves using all available tax savings strategies, such as tax-loss harvesting, payroll-deducted contributions and asset allocation, to outperform against a benchmark, adds Ken Peavy, vice president of wealth management for MAX Credit Union.
Tax savings. Tax savings is the difference in the tax bill for a portfolio that uses tax-loss harvesting versus another without tax-loss harvesting. A financial advisor can explain how your investments’ performance benefits from tax management, and how much you’ll save by following a tax-loss harvesting strategy.
“Tax-loss harvesting, or selling at a loss, is a classic example of tax savings to the investor,” says Peavy.
How Much Does Tax-Loss Harvesting Save Investors?
Tax-loss harvesting is also commonly understood by investors as the “lemonade approach.” In a year like 2022, when the stock and bond markets dipped into double-digit territory for an extended period, this strategy helped some investors make proverbial lemonade out of their “sour lemon” circumstances.
It’s hard to fully quantify how many investors take advantage of the lemonade approach in any given year, but there are ongoing reports that attempt to measure its impact on investors’ financial plans over time. For example, Vanguard’s “Tax-Loss Harvesting: A Portfolio and Wealth Planning Perspective” white paper reveals that from 2000 through 2019, tax-loss harvesting helped many investors earn an average, annual benefit of 0.95%, an equivalent of almost an extra 1% in portfolio return.
In a separate study, which spanned 92 years, from 1926 to 2018, the Massachusetts Institute of Technology found that tax-loss harvesting provided some investors with an average benefit of 1.1%.
The tax-loss harvesting strategy is not just limited to affluent investors, and it can be deployed each calendar year. Still, because tax-loss harvesting is an integrated strategy, it’s most effective when investors use it to support their overall, long-term financial plan, not attempt to carry it out in isolation from the plan.
More from U.S. News
How to Pay Taxes on Investment Income
8 Ways to Minimize Taxes in a Taxable Investment Account
8 of the Best Tech Dividend Stocks to Buy
Tax-Loss Harvesting Rules and Strategies for Investors originally appeared on usnews.com
