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