Determining If Tax-Loss Harvesting Is Right for You

Wealth can be created from the reinvested tax savings. If the investor is in a higher tax bracket in the future when the recovery gain is realized, the tax benefit may be smaller. Benefits are greater if the market decline is larger, which produces more losses to harvest and more tax savings generated in the first place. Benefits are also greater if subsequent returns are higher, allowing more compounding on the tax savings. Conversely, with smaller market declines, lower tax rates and lower returns, the benefit of tax-loss harvesting is diminished. This example does not include a discussion regarding transaction costs, which should be factored in as well.

Consider the case of an investor at peak wage-earning years now with income being taxed at the top tax brackets and a capital gain rate of 23.8%. The investor plans to retire in the next few years and the anticipated capital gain rate during retirement will fall to 15%. Wealth can be created by the difference between the current and future tax rates.

If there is an opportunity to harvest a loss at ordinary income tax rates, the tax arbitrage is greater. The spread could be 40.8% versus 23.8% at the top tax rates.

Not Always a Successful Strategy

Tax-loss harvesting can result in adverse tax bracket changes. For example, an investor could harvest losses for years at the lower capital gains rate of 15%, but in order to recover the original investment, the gain could be large enough to be taxed at the 23.8% bracket. This is negative tax arbitrage.

In general, capital losses can only be deducted to the extent the taxpayer has capital gains in the same year. Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. You may use up to $3,000 ($1,500 for married filing separately) of total capital losses in excess of total capital gains as a deduction against ordinary income in computing your adjusted gross income (AGI). Any unused losses can be carried over to next year.

That begs the question: Should you bank a loss when you have no gains to offset it in the current year in hopes that there are future capital gains for the carryover losses to offset or until the ordinary income is eventually used up? Ensuring that you realize the benefit of taking a large realized loss means that you expect to have realized gains in the future to offset it. So, if you expect a large realized gain in the future, like the future sale of a business or other investment property, this strategy may work. If you cannot utilize the carryover losses, you may have exited an investment earlier than you would have, if not for the tax benefits you were hoping to realize.

Another risk is that if the taxpayer dies before all carry over losses are used up, the remaining losses do not carry over to heirs or surviving spouses. They are lost.

Be Aware of Wash-Sale Rules

To prevent tax-loss harvesting abuses, Congress created the wash-sale rules. These rules prohibit selling an asset to capture a deductible tax loss and then immediately buying it back to maintain the position. This applies if the taxpayer purchases what the IRS calls a “substantially identical” investment within 30 days before or after the day of the sale that resulted in a loss. The rationale is that the taxpayer has not substantively changed his/her economic position, so no loss should be allowed. Also, selling a security in a taxable account and then purchasing the same security within 30 days in an IRA of either spouse will likely trigger the wash-sale rules.

Here are some ways you can substantially preserve an investment position while realizing a tax loss:
 

• Sell the original holding and then buy the same security at least 31 days later. The risk is interim upward price movement.

• Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is interim downward price movement.

• Sell the original holding and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.

• For mutual fund shares or exchange-traded funds (ETFs), sell the original holding and buy shares in another mutual fund or ETF that uses a similar investment strategy. However, be careful in employing this strategy. The IRS guidelines for these are confusing as to what is deemed substantially identical for wash-sale purposes. Be cautious in pushing the limits with tax-loss harvesting of mutual funds and ETFs.