What is tax loss harvesting?
During times of market volatility, it’s very normal for stressful emotions to come up, and for you to wonder if you should sell your investments. Provided you’re in a diversified portfolio and you have an asset allocation appropriate for your goal’s time horizon, market downturns are not when you should sell. According to JP Morgan’s Q2 2022 Guide to the Market, since 1980 the US stock market (defined by the S&P 500) has dropped on average by 14% intra-year. At the same time, annual returns were positive 76% of the time, with an average annual return of 9.4%. We think of drawdowns, or risk, as the cost of doing business when it comes to investing in the stock market. Your reward for staying invested are returns that outpace inflation, and if you’re consistent with saving and investing, over the long run, you have the ability to create generational wealth.
In this week’s blog, we want to highlight what can be done when investments are losing money, a strategy called tax loss harvesting.
Tax-loss harvesting is the process of using your investment losses to lower your tax liability and better position your taxable (i.e., not retirement) portfolio moving forward.
A quick reminder for all taxable accounts: when you sell an asset for a profit (or gain) you owe capital gains taxes based on how long you’ve held the asset. If you’ve held onto the asset for more than one year, you’ll be taxed at the preferential long term capital gain rate; alternatively, if you’ve held onto your asset for less than one year, you’ll pay the short term capital gains rate, which is taxed as ordinary income.
Tax-loss harvesting generally works in this way:
You sell a security that has lost money, thereby banking the loss for tax purposes.
You use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income on your tax return.
Finally, you reinvest the proceeds of your sale into a new security that matches your target risk profile and asset allocation.
The result of tax-loss harvesting: you lower your tax obligation by taking capital losses, while maintaining your portfolio's exposure to the market. In short: you pay less tax, and remain invested.
Tax-loss harvesting in action
If you reviewed your portfolio in the past month, it’s likely that you’d own securities that could be a good candidate for tax loss harvesting. Here’s an example of how one would be able to use tax-loss harvesting to their advantage:
Imagine you’ve invested in a well-diversified, global portfolio of stocks and bonds. You work in tech, you receive stock compensation from your employer, and your advisor has told you that your portfolio is overexposed to tech stocks. You and your advisor decide that you should diversify your portfolio, and reduce your exposure to the tech sector.
Upon review of your portfolio, you have a gain in Investment A (a tech stock) that was purchased less than a year ago. Another one of your investments - Investment B - is a tech stock you also purchased less than a year ago; you hold Investment B at a loss. You and your advisor decide to sell both of these positions to tax-loss harvest and diversify away from tech.
Let’s say you sell shares of Investment A and realize a gain of $20,000. Since you’ve held the stock for less than a year, this gain is treated as a short-term capital gain, which is taxed at your ordinary income rate.
You also sell shares of Investment B for a short-term capital loss of $25,000. Your $25,000 loss completely offsets the $20,000 gain from Investment A, meaning you’d owe no taxes on the gain. You also could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The $2,000 that’s left over is then carried forward year over year to offset future income until it has been used up. Assuming you’re subject to a 35% marginal tax rate, you could potentially be shaving off $8,050 in capital gains tax come tax time (not to mention the 10+% you might pay to California or New York!):
By selling Investment B for a loss, you’ve created a tax asset - an asset you can use to offset taxes. In this example illustrated by the Schwab Center for Financial Research, selling Investment B saves you the $7,000 you’d owe from selling Investment A. The additional $5,000 in losses reduces your ordinary income by $3,000 and enables you to bank an additional $2,000 of losses for a future year.
The final piece of this tax-loss harvest is the reinvestment. Now that you have cash on hand from the sale of both securities, you’re able to put the proceeds into other investments that will diversify you away from the tech sector.
While investors who have taxable portfolios can benefit from harvesting tax losses any time, down markets like the one we’re experiencing in the first half of 2022 may offer a great opportunity to realize losses and use proceeds to purchase other securities at a lower price. If you’ve been waiting for an opportunity to transition into a more diversified portfolio, this may be a good time to speak to your financial advisor about making some adjustments.
Tax-Loss Harvesting: Don’t Try This at Home! (Or By Yourself)
If you’ve worked with us at Mana, you know that money is also about feelings. According to Rob Kuharic, the Director of Tax Managed Solutions at Russell Investments, “One of the biggest obstacles to this strategy being used effectively is often the investors themselves. Most people don't like hearing they've lost money. They find it difficult to sell an investment at a lower price than they bought it at. The term loss-harvesting requires them to acknowledge an investment loss. In other words, they feel they are admitting they were wrong. So, psychologically, it can be difficult to tax-loss harvest.”
The disposition effect describes the tendency we have to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. Although it’s psychologically hard to make the decision to sell a losing asset, imagine how your portfolio would evolve over time if all you did was hold onto losing assets.
In addition to the psychological hurdle of creating tax losses for your own portfolio, there are some technical nuances that every investor should also be aware of:
The wash sale rule. After you’ve freed up cash from the sale of security, it’s likely that you’ll want to buy a security with similar investment attributes so that you can maintain your target risk profile and asset allocation. While this is allowed, there are specific rules that prohibit you from selling a security at a loss and then immediately buying the same stock, or even one that’s nearly identical. We highlighted an example of a DIY investment gone wrong in our blog last year.
The wash sale rule prohibits selling an investment for a loss and replacing it with the same or a ‘substantially identical’ investment 30 days before or after the sale. Some investors choose to hold cash while waiting 31 days before repurchasing the original security to avoid the wash sale rule. In a highly volatile market, this might not be the best strategy.
Cost basis calculations.
The cost basis of your investment is the original price you paid for the investment. In order to calculate your gain or loss, you’ll need to know your cost basis as well as the date you purchased your investment. Although this seems fairly straightforward, cost basis calculations can get more complicated if you are dollar-cost averaging into your portfolio.
Market volatility and the losses we’ve sustained so far in 2022 are not for the faint of heart; however, they are a necessary part of a healthy and functioning system. We hope we’ve shed some light on how it’s possible to rebalance your portfolio and bank tax losses through tax-loss harvesting. As always, if you are not a client, we highly recommend consulting with your financial advisor before tax-loss harvesting in your portfolio.
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Stephanie Bucko and Cristina Livadary are fee-only financial planners based in Los Angeles, California. Stephanie is the Chief Investment Officer and Cristina is the Chief Executive Officer at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. As fee-only fiduciaries and independent financial advisors, Stephanie and Cristina never receive commission of any kind. Stephanie and Cristina are legally bound by their certifications to provide unbiased and trustworthy financial advice.