We’ve all heard the saying, “When life gives you lemons, make lemonade.” That same attitude can serve investors well when managing their non-retirement investment portfolios. Naturally, investors tend to place a lot of their efforts on maximizing returns but often fail to pick up the “low-hanging fruit” that can increase their net returns after taxes. Harvesting losses during periods of market volatility is an easy, and often overlooked, aspect of successful investment management.
The Recipe - How Tax-Loss Harvesting Works
Tax-loss harvesting involves selling investments that currently show a loss on paper relative to the initial purchase price. The proceeds of the sale are then invested in a similar investment. IRS rules require that you not re-purchase the original investment for 31 days if you want to recognize the loss on your tax return. This is known as the “wash-sale rule.”
Here’s an example:
If your $10,000 investment declines in value to $8,000, you can sell that investment for a $2,000 loss and invest the proceeds in a similar, but not substantially identical, investment. The realized loss of $2,000 can be used to offset any capital gains you have from other investment sales. If you have no capital gains, the loss can be used to offset ordinary income (up to a maximum of $3,000 per year).
The strategy is most effective during volatile markets and thus should be exercised throughout the year, not just at year-end.
Other Key Points:
- There is no limit on the amount of capital gains you can offset. If you had gains of $30,000 during the tax year, offsetting those gains with $30,000 of losses would save you $7,140 (assuming a capital gains tax rate of 23.8%). Your investment portfolio would remain fully invested, but your tax bill would be lower. These tax savings won’t show up on your statement’s performance numbers, but they will fatten your checking account.
- Harvested losses greater than $3,000, and not offset by gains, can be accumulated, and used in future years, as they never expire. Accumulated losses provide flexibility to tax-efficiently reposition your portfolio during periods when your investments have considerable unrealized gains.
- Combining tax-loss harvesting with rebalancing (repositioning your portfolio’s allocation back to the long-term targets) is a powerful way to take advantage of market volatility.
How To Take Action
Without question, the most important part of reaping the benefits of tax loss harvesting is to do it! Over several years, this process can often save tens of thousands of dollars in tax savings for larger portfolios. Sadly, tax-loss harvesting can end up being a “rearview mirror” conversation when opportunities are missed. That’s why we’ve made it a key part of our process when managing client assets. If this is something that an investor wants to tackle on their own, here are the main things you’ll need to be prepared to do:
- Monitor your non-retirement investment account continually and look for meaningful losses to harvest.
- Be prepared with a researched investment that fits your long-term strategy.
- Pull the trigger – you must make the trade!
- Keep track of the 31-day wash sale rule if you want to repurchase the investment that was replaced.
- Be prepared to do it again in the future!
Investing, as we know, is a journey and there will be moments of highs and lows along the way. That’s part of the process of long-term successful investing. What investors do or don’t do in those moments of highs and lows often has the biggest impact on their ultimate destination. Like a refreshing glass of ice-cold lemonade on a hot summer’s day, monitoring and executing tax loss harvesting strategies is one way investors can turn a negative into a positive when their investment portfolios face more difficult times.
Compliance Notes: Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.
