With the stock markets down, you may be concerned looking at the performance and value of your investments. Some of your securities, which you may have intended to hold for the long term, may be significantly declining in value. So is this the time to stay the course or is there another option?
Under similar circumstances, we often guide clients in tax-loss harvesting. While a fairly common practice, we have found many people may be unfamiliar with this strategy because sometimes it is perceived as a brutal reminder of how economic conditions negatively affect investments. However, when done properly, tax-loss harvesting can be a positive tactic that can help transform a “bad” situation. We’ll share what tax-loss harvesting is, when you may consider it for your financial situation, and factors you should be aware of to ensure you optimize its benefits.
What is Tax-Loss Harvesting?
Tax-loss harvesting involves selling a security that has declined in value, which realizes the loss for tax purposes, with the intention of re-purchasing it in the future. To ensure your portfolio doesn’t change significantly regarding allocations, exposure, and holdings, the strategy also includes immediately purchasing another security comparable to the sold asset. You must wait 31 days before selling the replacement security and re-purchasing the original security.
Due to the waiting period, tax-loss harvesting is not “timing the market” but getting back into the original security holding with minimal disruption to the portfolio and your investment profile.
When Might You Consider Tax-Loss Harvesting?
In addition to maintaining your original investment profile, incurring losses through tax-loss harvesting enables you to cover current tax liability by offsetting taxable income and capital gains. So you may consider the strategy toward year-end if you have significant taxable income or capital gains, or you anticipate future capital gains within your portfolio or outside of it, for example, if you earn a profit selling a business or real estate. Known as a tax-loss carry forward, you can also “bank” significant losses and potentially use them for several years in the future to reduce taxable income and offset capital gains. At the very least, you can use capital losses to offset up to $3,000 of ordinary income in the current year.
Ultimately, tax-loss harvesting is a method that can help make your portfolio more efficient without tax consequences while the market is down.
Factors to Consider Before Tax-Loss Harvesting
Before harvesting certain losses, there are some factors to evaluate, with a financial advisor, including:
- The Loss Amount: Because tax-loss harvesting involves a few transactions and some disruption to your portfolio, you should first consider if the loss is significant enough to make it worthwhile for your financial situation. We generally guide clients in looking at losses greater than $3,000 to $5,000 to ensure trade costs are a small portion compared to the actual tax savings.
- The Wash Sale Rule: The trickiest part of tax-loss harvesting is avoiding triggering a wash sale. A wash sale occurs when selling a security and purchasing the same asset or an indistinguishable one within the 31-day period, a window of 31 days before and after selling the depreciated security. A financial planner can help you stay in the market with a similar investment profile while avoiding a wash sale that effectively negates the loss and tax benefit.
- The Account Type: Tax-loss harvesting can only be exercised in taxable accounts and serves no purpose in IRA or retirement accounts.
The relatively straightforward process of tax-loss harvesting stands to provide significant benefits in current and future tax years. There is still time to use this and other tax strategies before the end of the year to offset your income or any capital gains you’ve incurred. If you’d like to discuss the process and leverage the tax benefits, please get in touch with our team and we’d be happy to learn more about your financial situation to help you get started.
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CCMI provides personalized fee-only financial planning and investment management services to business owners, professionals, individuals and families in San Diego and throughout the country. CCMI has a team of CERTIFIED FINANCIAL PLANNERTM professionals who act as fiduciaries, which means our clients’ interests always come first.
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