How Valuable is Tax-Loss Harvesting?
For decades, disciplined investing has been a principle that countless investors continue to abide by. The idea is to imbibe healthy investment habits to create wealth for the long term because, as per the basic tenets of investing, one needs to stay invested long term to generate exponential gains.
But, as a result of market volatility and precariousness, some investments may not pan out as you expected them to. Moreover, it might often happen that you are making losses on a few investments. Nevertheless, loss-making investments are no longer something to mope over. If you have incurred losses in some of your investments, there is a silver lining, as these loss making investments can help reduce your tax liability. This is possible with a strategy called 'tax-loss harvesting’. If you wish to learn more about tax-loss harvesting strategies and how you can use them to lower your taxability, consult with a professional financial advisor who can advise you on the same.
Let us read further about how tax-loss harvesting works and understand why this strategy is valuable for an investor.
What is tax-loss harvesting?
Tax-loss harvesting refers to a strategy wherein taxpayers can reduce their tax liability when they sell an investment at a loss. A loss-making investment can be strategically used to reduce other investments' net profit. You are entitled to a tax deduction for the losses you might have incurred on your investments. Further, the amount is deducted from your ordinary income, including the gains made from selling profitable investments.
Tax-loss harvesting can also be understood as writing off the loss-making investments. The key thing to remember is that this is applicable in the same calendar year, i.e, you cannot claim a tax deduction for the losses made on your previous year's investments to reduce the taxes on your gains in the current calendar year.
The IRS allows taxpayers to claim a net loss of up to $3,000 per year for selling loss-making investments.
How does tax loss harvesting work?
Tax-loss harvesting works on one basic principle: to sell your loss-making investments (in the same calendar year) to avail tax rebate. The capital gains made from investments are taxable. Thus, selling your losses can offset the profit, leading you to pay less taxes.
Let's understand this with an example.
Suppose you sell ABC stock and book a profit of $10,000. On the other hand, you notice that your investment in XYZ stock is making you a loss of $5,000. Consequently, you can offset the profit of $10,000 with the $5,000 loss. As a result, your net profit will be $5,000.
Essentially, you are 'harvesting' the $5,000 loss and ensuring that you reduce your taxable gains. If you were to not harvest the loss, you would be paying taxes on $10,000. Having offset the profit with the loss, you are now paying taxes on $5,000, which is significantly lesser than the taxes on $10,000.
Why is tax-loss harvesting important?
Tax harvesting is a crucial tool for investors who want to reduce the amount of money they pay in taxes on their capital gains. It is a great way to use a loss-making investment to your benefit to ensure you get the most out of your capital.
Tax loss harvesting can benefit you in the following ways:
1. It helps in portfolio rebalancing
Expert investment portfolio managers suggest that investors ought to assess their portfolios at equal intervals in a year and make rebalancing decisions. This ensures optimal asset allocation and balancing between returns and risks.
Tax-loss harvesting can be used to reduce your tax liability and rebalance your portfolio. Whenever you assess your portfolio and make some sell decisions, there may be instances where you will incur losses or gain a profit. Further, you will have to allocate the funds to other securities in your portfolio. Thus, you stand to gain from dual benefits – rebalancing your portfolio with tax-loss harvesting.
2. It allows you to receive a tax break even if profits are not booked
Let's assume that you didn't book any profit on your investments in a certain calendar year. However, you may have sold some loss-making investments. In a situation where there is no profit but a loss, you can use tax-loss harvesting to reduce the taxes you will pay. However, you have to be careful and ensure that you invest the proceeds.
For example, if you sold ABC stock at a loss of $5,000 and fell in the 30% tax bracket, you can claim a tax rebate of $1,500 even if you booked no profit. But, remember, you may then have to invest this $1,500 into similar securities.
3. It can be advantageous in a bearish market
When the market is trading on the downward side, tax-loss harvesting can be an effective strategy to minimize losses and increase the potential for future gain. When stocks trade at a lower value in a bearish market, you may face losses. You can use a bearish market to buy fundamentally strong stocks that are generally quite expensive. The proceeds from tax-loss harvesting can be used to purchase such securities at a low price.
4. It helps reduce tax penalties from high capital gains
If you are making high capital gains in the short term, you may have to pay some of the highest taxes based on your income level. Similarly, the capital gains may run in five or six figures for high-value investors. In such a situation, tax-loss harvesting can be helpful as it may help reduce your capital gains and, thus, your taxable income.
Things to consider before tax-loss harvesting
Although tax-loss harvesting comes across as an effective tax-saving strategy, there are a few things you need to keep in mind:
1. Not considering the 'wash sale' rule
Tax-loss harvesting has many caveats to it. One of them involves investors claiming a loss to reduce their profits and immediately rebuying the security. This prompted the IRS to put the 'wash sale' rule wherein you are prohibited from buying the same security immediately after selling it to harvest tax loss. Therefore, you will need to ensure that you do not repurchase identical securities for 30 days after selling them for tax-loss harvesting.
2. Selling a security to get a tax rebate
Stocks generally undergo short-term volatility. However, the long-term gain on those stocks might be huge against a slight dip in their price. Therefore, if you plan to hold onto a specific security for the long term, you might want to reconsider selling the security.
3. Using tax-deferred accounts
It is important to remember that the tax relief offered by tax-loss harvesting can only be claimed in taxable accounts and not tax-deferred accounts like IRA or 401(k) accounts.
4. Not taking into account the service fees
You must be aware about the service fees that are levied on preparing the paperwork for tax-loss harvesting. If you engage in multiple tax harvesting transactions for a particular calendar year, you may pay a higher service fee, which is counterproductive. This can burn a hole in your pocket and reduce the possibility of offsetting any capital gains or ordinary income tax savings.
To summarize
For an investor, tax-loss harvesting can be effectively used to help offset losses against profits, thereby reducing their tax liability. The most significant advantage of using tax loss harvesting is that you can easily save up to $3,000 in taxes. While this may not look like a sizable chunk to many, the power of compounding can help you make a fortune here.
However, tax-loss harvesting must not be used at each and every opportunity you get. Over the years, the performance of the security has to be studied to analyze whether selling it to get a tax relief makes sense or not. When misused, indulging in tax-loss harvesting may interfere with the habit of disciplined investing. Thus, investors must consult with an experienced investment advisor before making such decisions.
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