Investors can employ several techniques during market downturns to improve long-term returns. One of those techniques is called “tax-loss harvesting.”
Tax-loss harvesting is the process of selling a security at a loss while simultaneously buying into a highly correlated security. The idea is to keep the same strategic position in the market while gaining the benefit of booking the loss on your taxes.
For example, suppose you harvest $30,000 of long-term losses this year and that you have no other sales. You could deduct $3,000 of those losses from ordinary taxable income and “carry forward” the remaining $27,000 of losses to future years to offset gains or deduct from ordinary income.
Continuing the example above, let’s say you are married, file a joint tax return, and in the 24% tax bracket for federal income tax, and 20% rate for long-term capital gains tax. In 2022, your potential tax savings is $720 ($3,000 * 24%). Then, in 2023, you sell an investment for a long-term capital gain of $24,000, so you could save $4,800 ($24,000*20%) in tax liability and use the remaining losses to offset another $3,000 in ordinary income, saving another $720. So in this example, the tax- loss harvest strategy in 2022 saves you $6,240 over two years.
One hazard of tax-loss harvesting is that the IRS prohibits booking a loss if you repurchase something “substantially similar” within 30 days of the sale. This is called the “wash sale” rule. Therefore, it is imperative that you buy a substitute security that is highly correlated with the original security, but still dissimilar enough to avoid the wash sale rule. For example, a person who sells an actively managed Large Cap US Equity Mutual Fund might purchase a Large Cap Index ETF.
Another point to remember is that this strategy only applies to taxable brokerage accounts, not retirement accounts. One cannot deduct losses generated in a tax-deferred account such as an IRA or 401(k).
Although we cannot control the markets, it is possible to take advantage of tax savings opportunities when they arise. If you need help harvesting your losses, it might be time to work with an advisor. By choosing to work with a fiduciary advisor, you can feel confident that all advice is given with your best interest as the goal.
Services offered through Hurlow Wealth Management Group, Inc., a Registered Investment Adviser. Hurlow Wealth Management Group, Inc. does not provide tax, legal or accounting advice. Advisory services are only offered to clients or prospective clients where Hurlow Wealth Management Group, Inc. and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Hurlow Wealth Management Group, Inc. unless a client service agreement is in place.
