Marcus P. Miller, CFP®
Tax Loss Harvesting - Is it worth it?
The recent drop in the stock market has primed the conversation on tax loss harvesting for end-of-year tax planning.
What is tax loss harvesting?
Investments in stocks and bonds typically increase in value over time. When you sell a security that has increased in price, the tax applied is called a capital gain. If you sell a security that has decreased in price, you record a capital loss. A gain is taxed and a loss reduces your taxes. This article only applies to taxable accounts, excluding 401k, 403b, and IRA's due to their tax advantaged status.
A capital loss can directly offset a capital gain if it occurs within the same year. The process of systematically “harvesting” capital losses for the purpose of offsetting capital gains tax is typically referred to as tax-loss harvesting.
The process is simple:
Sell a security that has decreased in value from when you bought it
Reinvest the money in a different security that is not “substantially identical”
The difference in price between the amount you purchase the original security for and the amount you sold it for is your tax loss. This tax loss can be used to offset your other gains or even a portion of your other income.
Capital losses are applied to capital gains of the same type. This means that a long-term capital loss is applied to a long-term gain and a short-term loss to a short-term gain.
Advanced planning note:
While the process to perform tax loss harvesting is simple, the details surrounding its execution can get complicated. For example, the wash sale rule negates any tax loss harvesting if you purchase a “substantially identical” security within 30 days of selling the original security. Let's call this the 30-day rule. The IRS applies this to all accounts including brokerage, tax-free, IRAs, 401k/403b, and even spousal accounts. It applies to stocks, bonds, and options. Selling equity in one company and simultaneously purchasing an option in the same company will trigger the 30-day rule. Selling equities in your account and buying them in your spouse's account will trigger the 30-day rule, Etc. The 30-day rule cancels out any benefit of tax loss harvesting.
Overall, tax-loss harvesting allows you to defer taxes until you sell the security that was reinvested in.
Who should use tax loss harvesting?
Because tax-loss harvesting allows you to defer taxes, it is more useful for individuals in high-income tax brackets and those with longer time horizons. Additionally, if someone intended to never sell the securities (ie. pass them to heirs, or donate them to charity) then tax-loss harvesting would benefit them substantially more. This is because they would see the benefit of the tax loss today, and never actually pay the tax due to a step-up in basis when they pass away or donate the shares.
When tax loss harvesting, proceeds from the sale today will be reinvested and eventually sold (hopefully) at a profit. This will create a larger tax bill in the future. This can be a large benefit if you are expecting to be in a lower tax bracket in the future. Also, the decrease in taxes today will allow for the saved taxes to be invested and compound over time. When the tax bill is paid later (when the reinvested assets are sold) the compounded investment on the dollars “saved” due to the earlier tax loss harvesting will be a net gain.
Who should be wary of tax loss harvesting?
Tax loss harvesting is not for everyone. Some individuals or married couples who are in a lower tax bracket would not benefit from this at all. They would reduce a tax bill in the current year (a low tax year) and likely increase their tax bill later, when they may be in a higher tax bracket. Additionally, if the reinvested assets are sold quickly (say, less than 5 years) then the benefit of tax loss harvesting would be minimal at best. Some roboadvisors include tax loss harvesting with their asset management but do not do the calculations into whether this will benefit your specific situation. Overall, autopilot of tax-loss harvesting can do more harm than good.
What is tax gain harvesting?
Tax gain harvesting is the opposite of tax loss harvesting. This is the process of selling your “winners” that have gone up and increasing your long-term capital gains for the current year. This can be a large benefit if done within the 0% long-term capital gains bracket.
Note: Harvesting capital gains only works for long-term capital gains. This means assets that you have owned for over a year.
A family who files jointly that makes less than $83,350 (2022 rate, including all income, capital gains, dividends, etc.) has a 0% tax on their long-term capital gains. That means harvesting capital gains up to this dollar amount every year (including other income) would essentially reduce their future tax bill and have no effect on taxes this year. As a bonus, the 30-day rule does not apply to harvesting capital gains. You can sell the “winners” and then immediately reinvest into the same exact asset. It is important to ensure that all income including capital gains remains under the 0% long-term capital gains threshold.
Advanced Planning Note:
There are a few considerations for tax gain harvesting. These include the possibility of doing a Roth conversion up to the next tax bracket (instead of tax gain harvesting). Typically, achieving a 0% long-term capital gain is preferable to a 10% savings on income tax (22% income bracket vs. 12%). However, there are situations where you may choose the Roth conversion option. Additionally, be cautious of matching any existing tax loss carryforwards. You want to apply these to years when you’re in a higher tax bracket.
Summary
Tax loss and tax gain harvesting are tools to improve your tax planning over the long term. It is crucial that these tools be implemented selectively as they can have the opposite effect if used in the wrong tax bracket or with the wrong timeframe.