Here’s some consolation for anyone who’s been hurt by the stock market this year: your portfolio’s bullishness may offer some benefits next tax season.
It’s a strategy called “tax loss harvesting,” and as year-end tax planning approaches, financial experts say this powerful strategy isn’t just for the wealthy.
“Anyone who is a taxpayer with investment dollars has an opportunity to take advantage of this, especially in a volatile market,” said Yuna Gruda, tax partner in the family wealth services group at Marcum, a national accounting and advisory firm.
Frank Newman, portfolio manager at Ally Invest, the brokerage arm of Ally Financial ALLY, said the phrase “tax loss harvesting” can be scary for some people.
““Anyone who is a taxpayer and has investment dollars has an opportunity to potentially take advantage of this, especially in a volatile market.”»
But people should not be intimidated by the tax tactic of capital loss harvesting to offset gains and reduce taxable income, he said. “This is a great strategy for anyone regardless of account size,” Newman said.
Selling at a loss is easy enough in this market. Even with a strong October, the Dow Jones Industrial Average DJIA,
is down about 12% year to date. S&P 500 SPX,
down more than 19% and the Nasdaq Composite COMP,
decreased by more than 29%.
To take advantage of the benefits of tax loss harvesting, investors must choose to invest in losses, and they must choose when to take those losses (and also not to quickly return to the same position due to tax rules). It’s like trying to time the market—many investment experts say people should avoid it when working toward their long-term goals.
Gruda said the strategy has a tax aspect and an investment aspect. “Often, these two goals do not coincide.”
That said, people shouldn’t let the “tax tail” wag the dog when it comes to investing (and the same goes for major purchases based on tax breaks, such as electric cars and energy-efficient home improvements).
But the market may prompt many to at least consider the idea of taking some profit from capital losses. Here’s a look at some of the finer points of the theme:
Learn the basics
Start with the capital gains tax rules. It includes stocks, bonds, exchange-traded fund shares, a piece of cryptocurrency BTCUSD,
and so on.
Sell at a profit and capital gain refers to the difference between the original cost to the owner and the sale. For many people, the long-term capital gains tax rate will be 15%, which means that the owner will hold it for at least one year before disposing of it.
The 15% rate this year applies to individuals filing between $41,676 and $459,750, and for married couples filing jointly it is $83,351 to $517,200.
Short-term capital gains are bought and sold within a year, so the IRS treats the gain as ordinary income that is lumped in with other income. After that, the tax is charged in whichever tax bracket the person lands in.
Sell at a loss and capital loss refers to the difference between the purchase price and the sale price. Losses offset profits, and then excess losses up to $3,000 can be deducted from income. The remaining losses are carried forward to future years.
According to Fidelity Investments, short-term losses offset short-term gains first, and long-term losses offset long-term gains first. After one type of benefit is completely canceled, the remaining amount of the loss can be applied to another type of benefit, Fidelity said.
For this reason, it is important to see that short-term losses can offset short-term gains that require a higher tax rate.
There is another starting point, Gruda said. How much will the potential tax benefit this year exceed the investment return of holding the investment and abandoning the strategy?
There is no answer, he said. In some cases, it can be very little. In others, it can be a great move. If a taxpayer is betting they will realize a large capital gain during 2023 or later, loss carryforwards can be a useful tool for placement.
However, Uncle Sam will eventually take a cut of the profit from the asset appreciation. Tax loss harvesting “lightens and delays tax reporting. It doesn’t eliminate tax liability down the road,” Gruda said.
Don’t be swayed by a laundry sale
Even if a person sells from their brokerage account or IRA at a loss, they still don’t want to permanently exit the portfolio position. They may want to invest now at a lower cost with room to grow again.
Wait a bit under the IRS’s “wash sale” rule.
The IRS does not calculate a capital loss if, within 30 days before the sale or within 30 days after, the taxpayer also buys or acquires a “substantially identical” investment. This rule applies to investments such as stocks, bonds, mutual funds, exchange-traded funds and options, but not cryptocurrency.
The trick is to just keep track of the days, Gruda said. He’s seen his share of people missing out on tax breaks because they didn’t watch the clock.
Another skill is to consider what is considered “substantially the same” for a fast-moving investor who sees a buying opportunity 30 days before or after the sale date.
An investor can sell the stock and buy an exchange-traded fund or mutual fund that includes the stock and not run afoul of the rule, Gruda said. Going the other way, from a mutual fund or ETF that owns stocks to directly buying stocks, also doesn’t trigger the rule, he noted.
Suppose an investor has several investment accounts – perhaps one for long-term trading and another for short-term trading. Newman noted that the rule applies across all accounts. So, if one sells and the other buys within 30 days before or after that, the wash sale rules eliminate the capital loss, Newman said.
Buying and selling shares of two different funds that track the same index over a 30-day period could also trigger wash sale rules, Newman said. However, a move like selling a chunk of an ETF that tracks the S&P 500 and then quickly buying an ETF that tracks the Russell 1000 Index would be fine, according to Charles Schwab SCHW.
“This preserves your tax benefit and keeps you in the market with roughly the same asset allocation,” the explainer said.
But while someone is looking at repurchasing and allowing the selling window to close in one place, they may have the opportunity to start the tax strategy process in another part of their portfolio. “There is potential for tax loss harvesting in a number of different asset classes this year,” Newman said.