Not everyone can be a winner, and that applies to your individual investments, too. You might have a conglomeration of winners and losers in your portfolio, and believe it or not, those “loafers” might actually be able to help you out if you take advantage of tax-loss harvesting.
Tax-loss harvesting means that you can minimize the pain of capital gains taxes. This must-do strategy reduces and defers taxes on investment income and supercharges your net wealth accumulation over time.
Overview: What is Tax-loss Harvesting?
Tax-loss harvesting simply means that you sell losing investments. You “harvest” the losses and offset those losses against any capital gains you may earn on your winners. The result: You can reduce or even eliminate your investment income tax liability.
Example of Tax Loss Harvesting
To illustrate the concept of tax-loss harvesting, let’s look at a very simplistic example.
If you have $10,000 in stock in a taxable account that doubles in value, you could easily sell it and “lock in” the profits. That would net you a $10,000 capital gain.
Investment Initial Value Outcome Value Action Tax Impact Winner $10,000 Doubles $20,000 Sell Pay tax on $10,00 gain
You’d then have to pay capital gains taxes on that windfall before you could take the proceeds and use that money for some other purpose. Though you turned $10,000 into $20,000, you still won’t have $20,000 to reinvest. Depending on your personal tax situation, you might lose anywhere between $1,500 to $2,000 to taxes and you’d be then left with between $18,000 and $18,500.
However, you look through your entire portfolio and see a $20,000 investment that’s also a terrible performer. What if it’s gone down $10,000 in market value? You see no sign of that investment ever recovering.
Investment Initial Value Outcome Value Action Tax Impact Winner $10,000 Doubles $20,000 Sell Don’t pay any taxes Loser $20,000 Halves $10,000 Sell Tax loss harvest
Why not sell that loser, harvest the $10,000 loss and use it against an equivalent amount of capital gain from the winner? This strategy will mean you’ll never pay taxes on the sale of a winning stock.
In real life, scenarios like this usually don’t magically align. In the example above, you’d end up no richer or poorer than when you started — your $30,000 investments will remain $30,000 in value. So, when used strategically, tax-loss harvesting can be a very effective investment strategy.
How Tax-Loss Harvesting Works
Here are a few more applicable suggestions for tax-loss harvesting:
1. Strategically offset winners against losers
In the first example, you sold two investments — one a winner and the other a loser — and didn’t pay any taxes. However, you don’t have to sell both your investments simultaneously in order to take advantage of tax-loss harvesting.
|Investment||Initial Value||Outcome||Value||Action||Tax Impact|
|Winner||$10,000||Doubles||$20,000||Sell||Don’t pay any taxes|
|Loser||$20,000||Halves||$10,000||Sell||Tax loss harvest|
Because the IRS allows you to carry your losses forward over multiple years and then apply them against future capital gains, you can use harvested tax-losses to strategically offset winners against losers. Instead of synchronizing your exits from both positions, do so at an opportune moment — perhaps when you need the money for an emergency or to fund a home renovation.
2. Allow pseudo tax-deferral in taxable accounts
Tax-loss harvesting is a strategy available only in taxable investment accounts. That’s because these accounts are subject to capital gains. But you can use it to create pseudo tax-deferred investments, even though you hold them in taxable accounts.
Assume you have an investment in a taxable account that’s been a winner, returning consistently impressive gains over the five or 10 years you’ve held it. Why cut your gains, sell your winners and pay taxes on the capital gains when you can easily offset those gains by using tax-loss harvesting from other, not-so-successful, investments.
In doing so, you’ll make the power of compounding work for you. Your winner continues to benefit from the market momentum and, because you haven’t sold any of it, you’ve also deferred paying taxes on those gains every year. By the time you’re ready to retire in 20 years or more, your winner will have grown three or four-fold, but the tax liability upon selling it will be comparatively smaller because you are in a lower tax bracket.
3. Enable strategic reinvestment decisions
Tax-loss harvesting can also work if you’re holding losing investments but don’t see any immediate reinvestment opportunities from a potential sale of that loser.
|Investments||Original Value||Market Value||Capital Gains or (Loss)||Potential Tax %||Potential Tax Amount||Return on Investment||Strategy||Tax Impact|
|Investment #1||$45,000||$50,000||$5,000||15%||$750||$4,250||Don’t Sell: Hold||No Tax|
|Investment #2||$20,000||$10,000||($10,000)||0%||$0||($10,000)||Sell||No Tax|
|Re-Invested #2||$10,000||$11,000||$1,000||15%||$150||$850||Sell||No Tax|
In the example above, you don’t sell your $10,000 loser investment — Investment #2 — immediately. You study the market carefully and wait until you see a better investment opportunity to put those sales proceeds to work.
The $10,000 Re-reinvested #2 will (hopefully) start working in your favor. Assume you are in a 15% tax bracket. Since you’ve harvested $10,000 in tax losses, you’d have zero tax liability even if you now decided to sell both Investment #1 and Re-invested #2.
A word of advice: Tax-loss harvesting usually (but not always) occurs at the end of a tax year. Make sure you know what your applicable tax rates (marginal and capital gains) are before you make tax-loss harvesting decisions. You also need to ensure you don’t violate IRS rules on wash sales by buying the same (or similar) investments within 30 days of selling your previous holdings.
Consider the best free tax software to assist you when preparing your taxes.
4. Offset non-investment income
What if your tax-harvested losses exceed your capital gains? The IRS allows you to use investment losses to minimize your non-investment income.
Assume you harvested a tax-loss of $8,000, but only had $2,500 of capital gains this year.
|Harvested Tax Loss||Capital Gains||Unused Tax Loss||Applied Against Non-Investment Income||Harvested Loss Carry Forward|
After offsetting that $2,500, you’d still have $5,500 of your harvested tax loss available to use, but the IRS has a limit on such deductions. If you and your spouse are joint filers, you could use it to offset up to $3,000 ($1,500 if married and filing separately) of non-investment income. You can carry forward the remaining $2,500 in harvested losses for future use.
What Brokerages that Offer Tax-Loss Harvesting
Tax-loss harvesting is a great tool if you want to minimize the taxes you pay on capital gains. However, there are several factors that go into the strategy, including keeping track of the cost basis of individual securities, timing the sell, buying decisions and awareness of your personal tax rates.
You could manage all of this in a spreadsheet, but things can really get complicated if you have multiple investment accounts and dozens of individual stocks, mutual funds and ETFs. All of these complexities are best left to computers and apps.
Most online brokerages and robo-advisors offer tax-loss harvesting as part of their core services. Some of the highest performing robo-advisors to consider include:
Betterment gives investors a leg up on implementing efficient tax strategies by automating asset allocation in its tax-coordinated portfolios. It automatically places highly-taxed assets in IRAs, while taxable accounts hold lower-taxed investments.
This strategy by itself can increase after-tax returns by approximately 15% over a 30-year period.
The company uses intelligent algorithms with its Tax Loss Harvesting+ feature to run daily checks for tax-loss harvesting opportunities.
Over a 13-year period, Betterment estimates that this no-cost feature, which combines tax-loss harvesting, wash sale management, and portfolio rebalancing, could potentially add 0.77% to a model portfolio.
Learn more about Betterment and take an in-depth look into the services they provide by reading our Betterment Review.
Wealthfront’s enhanced approach to tax-efficient portfolios includes the concept of differentiated asset allocation and improved bond diversification. The company estimates that this strategy could produce after-tax return of 0.50% per year.
The company also offers a free daily tax-loss harvesting service. Wealthfront monitors portfolios daily for tax-loss harvesting opportunities and Wealthfront’s system sells “loser” ETFs and purchases alternatives to replace it. The portfolio holds the alternative ETF until it’s strategically advantageous to sell it and harvest additional tax losses. This strategy also ensures that clients don’t accumulate capital gains and always comply with the IRA’s wash sales guidelines.
If you’d rather implement tax-loss harvesting using individual stocks instead of ETFs, you can personalize a stock-level tax harvesting strategy by managing various parameters, including exclusion lists, which override Wealthfront’s buy/sell decisions for those specific stocks.
Find our if Wealthfront is the right choice for you by comparing your options with our Wealthfront Review.
WiseBanyan calls its tax-loss harvesting strategy WiseHarvesting. WiseHarvesting harvests tax losses and immediately reinvests the proceeds.
This ensures locked-in deductions, and the portfolio stays 100% invested. Unlike traditional tax-loss harvesting strategies, which are based on first-in-first-out (FIFO) approaches, WiseHarvesting scans for smart tax lots and sells investments only with the lowest realized gains.
WiseHarvesting integrates several tax-efficient strategies including dividend reinvesting, portfolio rebalancing and asset allocation.
IRA transactions can often negate the benefits of tax-loss harvesting. WiseHarvesting also ensures that taxable portfolios always comply with IRA wash sales rules.
Compare WiseHarvesting and the WiseBanyan robo-advisor against your current needs with our WiseBanyan Review.
4. Personal Capital
Personal Capital’s clients benefit from multiple tax optimization strategies. These include not investing in tax inefficient mutual funds and smart asset allocation — holding high-yield stocks and non-qualified dividend payers in tax deferred accounts, Roth conversions and harvesting losses using individual stocks instead of high-cost mutual funds.
Through strategic tax-loss selling, Personal Capital client portfolios are automatically rebalanced back to model weight and simultaneously claim losses that can be offset against future gains. According to the company’s research, this strategy of tax-efficient investing can lead to an additional 40% improvement in after-tax portfolio returns over a 35-year period.
Take a closer look at Personal Capital’s services with our Personal Capital Review, to see if this is the right robo-advisor for you.
There’s no doubt that a tax-loss harvesting strategy is worth considering because of its ability to offset capital gains against losses, thereby allowing you to forgo paying capital gains taxes.
|Initial Investment||Rate of Return||Time Period (Years)||Terminal Value|
|Difference in Return:||$26,445.98|
|Rate of Return:||9.97%|
Even half a basis point added to portfolio returns over a 20-year period could leave you almost 10% richer, thanks to tax-loss harvesting.
Before you review your portfolio for potential tax-loss harvesting candidates, it’s important to understand how investments are taxed. Tax-loss harvesting works for investments you’ve held for less than a year (short-term investments) and those held for over a year (long-term investments). The IRS taxes short-term capital gains as ordinary income, while long-term gains are subject to the preferential long-term capital gain rates.