Many investors do tax loss harvesting at the end of each tax year. The strategy includes selling stocks, mutual funds, exchange traded funds (ETFs)and other loss-compensating investments realized profits from other investments. It can have a great tax advantage.
However, tax loss harvesting may or may not be the best strategy for all investors for several reasons.
Latest tax rates
The Internal Revenue Service (IRS), many states, and some cities assess taxes on individuals and businesses. From time to time, the tax rate – the percentage used to calculate the taxes due – changes. Knowing the latest investment rates will help you decide if tax loss harvesting is smart for you now.
Key things
- In order to decide whether tax loss harvesting is a smart choice, it is necessary to keep up with the latest rates regarding investments.
- The best case scenario is tax loss harvesting if done in the context of rebalancing your portfolio.
- One consideration in a given year is the nature of your profits and losses.
For tax years 2022 and 2023, the federal tax rates that apply to tax loss harvesting include:
- Top tax rate of 20% for long-term capital gains. Depending on your income, the rates are 0%, 15% or 20%, and the IRS notes that most individuals pay no more than 15%.
- Medicare tax for high-income taxpayers, which is 3.8% of investment income for taxpayers whose total income exceeds $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 USD for individuals.
- The ordinary income tax rate, which tops out at 37%. Depending on your income, your tax rate will be 10%, 12%, 22%, 24%, 32%, 35% and 37%.
All investors can deduct a portion of investment losses, but these rates make investment losses more valuable to high-income investors who take advantage of them.
Understand the washing rule
The IRS follows suit wash-sell rulewhich states that if you sell an investment to book and deduct that loss for tax purposes, you cannot buy back the same asset – or another asset that is “essentially identical” – for 30 days.
In the case of individual stocks and some other businesses, this rule is clear. For example, if you had a loss in Exxon Mobil Corp. and you would like to realize this loss, you would have to wait 30 days before buying Exxon Mobil stock. (This rule can actually be extended up to 61 days: You would have to wait at least 30 days from the date of the original purchase to sell and realize the loss, and then you have to wait at least 31 days before repurchasing that identical asset. )
Let’s look at a mutual fund. If you realized a loss in the Vanguard 500 Index Fund, you could not immediately buy the SPDR S&P 500 ETF, which invests in the same index. You could probably buy the Vanguard Total Stock Market Index, which tracks another index.
Many investors use index funds and exchange-traded funds (ETFs). sector funds to replace the inventory they sold without violating the laundering rule. This method can work, but it can also fail for many reasons: extreme short term gains for example, in a substitute security, or if the share or fund being sold appreciates significantly before you have the opportunity to buy it back.
You also won’t avoid the wash sale rule by repurchasing the sold asset into another account you own, such as an Individual Retirement Account (IRA).
Portfolio rebalancing
One of the best reasons for tax loss harvesting is to use it in context rebalancing your portfolio. Rebalancing means adjusting your assets back to your chosen mix of risk and reward after market volatility has knocked it down.
When rebalancing, look and pay attention to which shares to buy and sell cost basis (adjusted, original purchase value). The cost basis will determine the capital gains or losses on each asset.
You don’t want to sell just to realize a tax loss if it doesn’t fit your investment strategy.
Bigger tax bill on the way?
Some argue that consistently harvesting tax losses with the intention of repurchasing the sold asset after the wash-sale waiting period will ultimately reduce your overall cost basis and lead to more capital gains to be paid out in the future.
This could be true if the investment grows over time and your capital gain is larger – or if you misjudge what will happen to future capital gains tax rates.
However, your current tax savings may be enough to offset higher capital gains later. Consider the concept current valuewhich says that a dollar of tax savings is worth more today than the additional tax you have to pay later.
This depends on many factors, including inflation and future tax rates.
All capital gains are not created equal
Short-term capital gains are realized from investments that you hold for a year or less. Profits from these short holdings are taxed to you marginal tax rate for regular income. The Tax Cuts and Jobs Act set the current income rate range, from 10% to 37% depending on income and filing method, until 2025, when it may be revised or extended.
Long-term capital gains are gains from investments you hold for more than a year and are taxed at a significantly lower rate. For many investors, the rate of these gains is around 15% (the lowest rate is zero and the highest is 20%, with some exceptions).
For the highest income groups, an additional 3.8% Medicare surtax on investment income comes into play.
First, you should offset losses for a given type of holding with early gains of the same type (for example, long-term gains against long-term losses). If there are not enough long-term gains to offset all long-term losses, the balance of long-term losses can go to offset short-term gains and vice versa.
Maybe you had a terrible year and still have losses that haven’t offset the gains. Losses on remaining investments of up to $3,000 can be deducted from other income in that tax year, and the remainder carried forward to subsequent years.
Tax loss harvesting may or may not be the best strategy for all investors. It can be most beneficial if used as a side benefit to an annual portfolio rebalancing.
One factor in deciding whether to harvest tax losses in a given year is certainly the nature of your profits and losses. You’ll want to analyze this or talk to your tax accountant.
Distribution of mutual funds
With the stock market gains over the past few years, a lot mutual funds they shed substantial distributions, some of which are in the form of both long-term and short-term capital gains. These distributions should also factor into your tax loss harvesting equations.
What is tax loss harvesting?
Tax loss harvesting means selling one or more losing investments, usually at the end of the year, and recording that loss on taxes for the year, effectively reducing your total taxable income for the year by up to $3,000. Additional losses may be carried forward to future tax years.
When is tax loss harvesting a good idea?
Tax loss harvesting is a good idea if it fits your overall long-term investment strategy. That said, if you’re rebalancing your portfolio to bring it back in line with your personal risk/reward profile, you may want to ditch the loser stocks. But you wouldn’t want to sell a stock that you strongly believe will turn in the next quarter.
Consider harvesting tax losses as a consolation prize for making a bad choice.
How much can you claim in tax loss harvesting?
You can claim a maximum of $3,000 per year of loss, or $1,500 if you are married filing separately. You can carry forward further losses. For example, if your actual losses totaled $10,000, you could claim $3,000 for each of the three tax years and then $1,000 in the fourth year.
Bottom Line
It is generally a bad decision to sell an investment, even at a loss, solely for tax reasons. However, tax loss harvesting can be a useful part of your overall financial planning and investment strategy and should be one tactic to achieve your financial goals.
