What is Tax-Loss Harvesting?

As the end of the year approaches, your thoughts are likely turning to the hallmarks of the season: holidays, seeing family and friends, and tax-loss harvesting. Well, maybe not that last one, but no doubt you’ll hear much about this as it’s a favorite topic in the financial media at this time of year.

What is Tax-Loss Harvesting?

Tax-loss harvesting is nothing more than selling assets that are worth less than their original cost. The loss created by the sale of one asset can be used to offset gains of another asset in the calendar year in which the sale occurs. This positive effect occurs in the year of the sale.

The possible negative effect, however, can occur in subsequent years as the cost basis of the new asset that replaces the one that was sold is now at a lower basis (price). If the asset is later sold at a gain, the difference between the lower basis (price) and the gain will result in a higher tax liability.

It is possible, therefore, that the tax savings from losses in one year will be offset by higher tax liability in future years.

Is Tax-Loss Harvesting Legal?

Yes, tax-loss harvesting is legal. It is a strategy permitted under Internal Revenue Service (IRS) rules, though certain conditions must be met. The wash-sale rule is one such condition that must be adhered to in order to ensure the losses can be used to offset gains.

The Wash-Sale Rule

Although the IRS allows you to offset capital losses against capital gains, there is one important restriction: the wash-sale rule. When you sell an asset, like a stock, you realize the loss immediately. However, the wash-sale rule says that if you buy that same stock back, or a substantially identical security, within 30 days of the sale, the loss is not considered realized and you cannot use it to offset gains.

So, while you may hear a lot of financial media coverage encouraging tax-loss harvesting, you’ll hardly ever hear anything about when it’s better to avoid using this technique. We’ll explain.

PAY NOW OR PAY LATER?

We asked some of experts at Edelman Financial Engines to weigh in on this topic with respect to planning, and here’s what they had to say.

“One thing to understand is that in a plain vanilla case where all gains and losses are long-term, tax-loss harvesting typically results in deferring taxes, not eliminating taxes,” says Wei Hu, vice president of financial research.

“And if you happen to be in a higher tax bracket when those deferred taxes come due, you may end up paying more than you would have otherwise.”

Edelman Financial Engines planner, Claire Mork, director of financial planning, highlights another reason why future considerations are a key component of the decision-making process. “If a client will be in a higher tax bracket in the future, because of significant Required Minimum Distributions for example, tax-loss harvesting may not be appropriate because that deferral of taxes could ultimately result in a higher tax bill for the client.”

“And if someone has a lower-than-typical tax rate this year because of reduced employment income,” Mork adds, “tax-loss harvesting now is not favorable.”

The U.S. tax code is notoriously complicated, and that’s one of the reasons why the scenarios for when you should avoid tax-loss harvesting can range from somewhat straightforward, like those listed above, to much more complex.

Bill Tracy, a portfolio manager here at Edelman Financial Engines, also sees a potential problem with tax-loss harvesting related to the nuances of how short-term and long-term capital gains are viewed by the IRS.

“Many times, when you sell a position to harvest losses, you’ll immediately reinvest the proceeds in an alternative fund to retain some market exposure. If you need to move out of any of those new positions within a year and markets have rebounded, short-term gains are taxed at a higher rate and would offset some of the benefits of having harvested losses in the first place.”

Should I Sell Stocks at a Loss for Tax Purposes?

Deciding whether to sell stocks at a loss for tax purposes depends on several factors. If you have realized capital gains that you want to offset, selling stocks at a loss can be beneficial.

Additionally, if you have no capital gains, you can use up to $3,000 of capital losses to offset ordinary income each year. However, if you expect to be in a higher tax bracket in the future, deferring taxes through tax-loss harvesting might not be advantageous.

TAX-LOSS HARVESTING AND YOUR ESTATE PLAN

Depending on your individual circumstances and the specifics of your estate plan, in some cases, tax-loss harvesting may not be necessary.

 Your individual needs and goals needs to be personalized. And because of that, the different reasons for avoiding tax-loss harvesting can be just as unique. Here are just a few examples, shared by Andy Smith, executive director of financial planning:

• When you wouldn’t be able to claim any losses because you engaged in a wash sale.
• If you already have more capital gains losses, which can be carried forward, than you will ever use in your lifetime.
• If you don’t have a post-transaction strategy. Selling is one thing, but you should have a plan for what you’re going to do with your proceeds from your tax-loss harvesting.

How Much Can You Write Off with Tax-Loss Harvesting?

The IRS allows you to deduct up to $3,000 in capital losses against your ordinary income each year ($1,500 if married filing separately). Any losses beyond this limit can be carried forward to future tax years to offset future gains or income.

While tax-loss harvesting is often portrayed across financial media as a straightforward way to lower your tax liability, it’s not always that simple. Tax-loss harvesting can be a valuable part of an integrated financial plan, but there are many variables to consider.

Tax-loss harvesting can be an important component of your comprehensive tax planning and financial strategy. However, it can become quite intricate, so it’s advisable to consult with your financial advisor and have your tax professional determine if this approach suits your needs.