Published by Kevin Oleszewski
As the end of the year approaches, we start to think more and more about our tax picture. What boxes can we check to reduce our taxable income?
Tax-loss harvesting is one such approach. A tax-efficient way to rebalance your portfolio, tax-loss harvesting can help you offset earnings and get back to your target allocation. Tax-loss harvesting is traditionally thought of as an end-of-year event, because it can help you minimize your tax bill.
Consider tax-loss harvesting now, before you ring in the new year. And as you head into 2022, revisit this tax-efficient tactic at least quarterly to make the most of this strategy.
Here’s what you need to know about tax-loss harvesting, including the wash sale rule.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy that lowers your taxable earnings after you sell taxable investments and use those losses to offset the gains you have to claim as income. It can also allow you to push your capital gains further out, allowing you to save on your taxes in future years when your tax bill might be higher.
For example, if you sold some of your investments this year at a loss, but your portfolio is doing well, you can lower your taxable income by claiming that loss. Also, if your losses exceed your gains, you can claim up to $3,000 on your taxes to offset ordinary income.
Let’s look at a specific, strategic and tax-efficient example. Say you have stock in Verizon that you want to sell and purchase stock in another cell phone company, AT&T. If you had a big loss in Verizon, you want to capture that loss while maintaining exposure to a cell phone company.
Or, you might want to sell Verizon stock while it’s down to lower your tax footprint and soon after repurchase, because you believe it will rebound.
A savvy investor might turn to either of those strategic scenarios. But before you move on this strategy, remember the wash sale rule.
The Wash Sale Rule
Let’s talk about the wash sale rule for a minute. This Internal Revenue Service (IRS) rule prevents you from taking a tax deduction for a security sold in a wash sale.
A wash sale occurs when you sell or trade securities at a loss and you also do three things within 30 days before or after the sale:
- Buy a substantially identical security
- Acquire substantially identical securities in a fully taxable trade
- Acquire a contract or option to buy substantially identical securities
Essentially, you want your allocation to stay the same. You don’t want the savings on the tax to change your asset allocation. You have to be especially mindful of swapping a holding for a similar holding so you don’t trigger the wash sale rule.
So, going back to the Verizon and AT&T example, say you want to buy back the Verizon stock instead of purchasing AT&T – you have to wait at least 31 days to buy it back or you can’t claim the loss.
Who Should Engage in Tax-Loss Harvesting?
Generally, tax-loss harvesting is ideal for people in higher tax brackets since the idea is to help lower tax bills.
A group of researchers from MIT and Chapman University found that tax-loss harvesting yielded a tax alpha, or outperformance by using available tax-saving strategies, of 1.10% per year from 1926 to 2018.
However, it could also be useful for people in a lower tax bracket, since you could carry those losses forward to times when you might have a higher tax bill, like if you get a higher-paying job or the government raises tax rates.
Tax-loss harvesting will play a huge role in planning if we move into a higher-tax environment. Higher tax rates call for investors to pay closer attention to tax efficiency of their taxable accounts.
There are certain situations in which you should consider tax-loss harvesting:
- Your investments are subject to capital gains tax.
- You are able to use tax-deferred retirement plans to postpone paying taxes until you retire.
- You anticipate you’ll change tax brackets.
- You invest in individual stocks.
Questions to Ask Your Advisor About Tax-Loss Harvesting
If you don’t yet have an advisor, and you’re in the process of interviewing one, you should ask them to tell you about their process of rebalancing portfolios. They should explain to you how they do so and in what type of account they do so.
Here are a few more questions you can ask:
- Do you do tax-loss harvesting?
- How does tax-loss harvesting fit into your overall investment philosophy?
Connect With a Financial Advisor
While we tend to focus on tax-loss harvesting now at the end of the year, it could be a beneficial strategy all year, especially as we gear up to potentially enter a higher-tax era. But it’s imperative that you discuss this with your financial professional to determine the frequency and timing of tax-loss harvesting for your particular situation.
Reach out to our team today to discuss your financial plan and how tax-loss harvesting can fit into your strategy.
Kevin Oleszewski is not affiliated with Cetera Advisor Networks LLC. Any information provided by Kevin is in no way related to Cetera Advisor Networks LLC or its registered representatives.