In 2023, investors have witnessed increased volatility as the stock market oscillated from last year’s lows to summer highs before experiencing another decline this fall. Such fluctuations can test even the most patient investors, particularly those committed to staying invested through the market’s cycles. However, the silver lining is that such markets can offer substantial opportunities for tax-loss harvesting, which can be pivotal in bolstering long-term returns.
What is Tax-Loss Harvesting and How Does it Work?
Tax-loss harvesting can be effective when used as a deliberate strategy at opportune times throughout the year. At its simplest, the process entails selling a security at a price less than its cost, which generates a capital loss. While that may not sound appealing on the surface, by taking a loss and harvesting it, you can use it to offset any gains or income generated throughout the year, which produces immediate tax savings.
As part of the strategy, when one security is sold, another with similar characteristics is purchased to take its place in the portfolio. It’s possible to simply repurchase the same security, except you must wait 31 days to comply with the IRS wash sale rule. The rule states that if you sell an investment and buy the same (or a substantially similar) investment within 30 days, either before or after the sale, it may be considered a wash sale, which could be disallowed for tax deductions. The risk is that, by the time you can legally repurchase the security, the price increases substantially, making it a less desirable investment.
To avoid triggering the 30-day wash sale rule, consider buying an investment that isn’t substantially identical. For instance, if you sold shares of Apple stock and bought shares of Microsoft, they wouldn’t be deemed “substantially identical.” However, if you believe Microsoft doesn’t have as promising a long-term outlook as Apple, you might not feel as confident in your portfolio. An alternative strategy would be to temporarily replace your Apple shares with a “proxy” investment, like a technology ETF. After the 30-day period, you can then sell the ETF and repurchase Apple shares.
How Do You Get Lemonade Out of Tax-Loss Harvesting?
In practice, tax-loss harvesting can generate some substantial tax benefits. The tax code allows up to $3,000 of capital losses to offset yearly ordinary income. If your losses exceed $3,000, they can be carried to future years. When done correctly, you receive an immediate tax break while still owning an investment that can generate long-term returns. You may eventually sell the investment and owe long-term capital gains taxes at a lower tax rate. So, in essence, tax-loss harvesting is a tax deferral strategy. Still, it can substantially enhance the long-term performance of your investment.
Would you be better off writing a $1,000 check to the IRS today or waiting 20 years to write the check? Considering the power of the time value of money, the difference could be substantial. Assuming a hypothetical 7% compounded annual return on your investments, your $1,000 could be worth nearly $4,000 in 20 years. And, considering the same tax rates 20 years from now, you would owe roughly the same amount — $1,000 – which means you potentially earn an extra $3,000 on the money you would have paid in taxes 20 years earlier.
Tax-Loss Harvesting Should be Part of a Sound Investment Plan
The above scenario involves some assumptions that may or may not hold. No one can predict the future long-term performance of an investment with certainty, and tax rates can change substantially – higher or lower. Should tax rates decrease significantly, the future benefit could be less. However, there are certain situations where tax-loss harvesting can be highly beneficial. If you are investing for future generations, you can defer capital gains indefinitely, and the assets receive a step-up basis at death, eliminating the tax consequence. You can accomplish the same thing by donating the investment to charity.
A sound, long-term investment plan should include a rebalancing strategy to realign the portfolio to an investor’s target asset allocation. Tax-loss harvesting is a strategy within the rebalancing strategy designed to maximize tax benefits while maintaining the integrity of an asset allocation strategy. Like any strategy, tax-loss harvesting should only be performed in light of your overall financial plan and investment objectives. Because it involves elements of timing, security selection (to sell and buy), and tax implications, it is highly recommended that you work with an investment advisor steeped in portfolio management expertise.
Seek Expert Guidance on Tax-Loss Harvesting for Your Portfolio
Navigating the intricacies of tax-loss harvesting and understanding its potential benefits can be challenging. If you’re aiming to maximize the tax efficiency of your investments and align them with your long-term goals, we’re here to help. Schedule a call with the experienced financial planners at URS Advisory today. Together, we’ll assess the best strategies tailored to your unique situation and help ensure your portfolio is set for both current challenges and future opportunities.