Sean Gallagher, CFP®
While many tend to avoid looking at their investment account statements during bad markets, market downturns present unique opportunities for investors.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy commonly used to help capture current investment losses in the hopes of saving on taxable gains in the future.
Before diving into the strategy, it's important to note that only taxable brokerage accounts will benefit from it. Tax-loss harvesting in tax-deferred or tax-free retirement accounts will provide no benefit and could even prove detrimental to investors.
How Does Tax-Loss Harvesting Work?
In taxable brokerage accounts, investors use after-tax funds to invest in securities, such as an S&P 500 index fund. As the securities grow in value, the investor does not pay tax on any capital gain until they sell the security. Once they sell the security, they will have realized a capital gain and a subsequent tax liability on the investment gain in that same year. Whether they held the security for over a year, the gain will be either short-term or long-term, with long-term gains receiving favorable tax treatment.
Example: You buy an S&P 500 index fund for $10,000 on January 1, 2022. If you sell the fund on February 1, 2022, for $11,000, your $1,000 investment gain will be taxed as a short-term capital gain. If you sell the fund on February 1, 2023, for $11,000, your $1,000 investment gain will be taxed as a long-term capital gain.
Of course, there will be times when an investment doesn't pan out, and you lose money. In the example above, selling the S&P 500 index fund for $9,000 would mean you received a $1,000 capital loss, either short-term or long-term, depending on how long you held the security.
At the year's end, an investor can use their realized capital losses to offset any of their realized capital gains for the year. If, after netting capital gains and losses, the investor is left with additional losses, they may be allowed to take up to a $3,000* tax deduction with the losses, and the remaining amount is allowed to carry forward to future tax years**.
Example: After a long year of trading, an investor is left with a net capital loss of $100,000. That investor can take a $3,000 deduction against their income on their federal tax return and carry the remaining $97,000 capital loss to the following year. Even if they realized $94,000 of capital gain the next year, they would still not owe any federal tax liability on the gain and would still receive their $3,000 deduction.
Tax-loss harvesting is a strategy centered around selling investments with losses to capture the capital loss and using this tax loss to offset future capital gains.
Tax-Loss Harvesting FAQs
When the market is down, can I sell the investment to bank the tax loss and repurchase it?
Unfortunately, the IRS restricts this strategy with the wash sale rule. The wash sale rule prohibits selling an investment for a loss and replacing it with the same or a "substantially identical" investment 30 days before or after the sale. If you violate the wash sale rule, the IRS will not allow you to capture the capital loss.
If I want to sell an investment for the tax loss but can't repurchase it for 30 days, wouldn't I be selling at a low point and missing the future investment gain?
This is correct and is where the strategy becomes more complex. After selling an investment for a tax loss, the IRS does not let you buy the same or a "substantially identical" investment for 30 days. A substantially identical investment would include selling one S&P 500 index fund and buying another S&P 500 index fund with a different ticker symbol. Since the S&P 500 index is an index of US large-cap stocks, an investor can use an alternative fund as a replacement, such as the Russell 1000, another index for US large-cap stocks. After the 30-day window is complete, they can sell the Russell 1000 index fund and repurchase the S&P 500 index fund with no consequences.
Example: Your S&P 500 index fund has a $5,000 loss. You can sell the fund to capture the $5,000 loss and immediately buy the Russell 1000 index for the same amount. After 30 days, you sell the Russell 1000 fund and repurchase the S&P 500. You were able to take the investment loss for tax purposes but never left the US large-cap stock market.
Tax-loss harvesting allows investors to capture valuable tax losses while not compromising their investment allocation by leaving the market and missing future capital appreciation. This commonly used strategy does not break any IRS rules regarding wash sales. If there ever was a silver lining during a market downturn, perhaps tax-loss harvesting can provide that little benefit for investors.
*For an investor filing as Married Filing Jointly. A single investor would be allowed a $1,500 tax deduction.
**Carryforward applies to federal tax returns. State tax laws will vary.
Sean Gallagher is a CERTIFIED FINANCIAL PLANNER™ at HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Sean graduated from Virginia Tech’s financial planning program in 2018 and successfully passed the CFP® national exam in 2019. As a Financial Planner at HIGHLAND Financial Advisors, Sean works on developing comprehensive financial plans and investment management for all clients.