Pros and Cons of Annual Tax-Loss Harvesting

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Pros and Cons of Annual Tax-Loss Harvesting

At the conclusion of each fiscal year, many investors engage in tax-loss harvesting. To counterbalance realized profits from other assets, the technique entails selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments at a loss. It may provide significant tax advantages.

However, for a variety of reasons, tax-loss harvesting may or may not be the optimal option for many investors.

Newest Tax Rates

Individuals and companies are taxed by the Internal Revenue Service (IRS), numerous states, and certain towns. The tax rate—the proportion used to calculate taxes due—changes from time to time. Knowing the most recent investment rates might help you evaluate if tax-loss harvesting is right for you right now.

Key Takeaways

  • Keeping up with the newest investment rates is crucial to determine whether or not tax-loss harvesting is a good idea.
  • Tax-loss harvesting is ideal when done in conjunction with portfolio rebalancing.
  • The nature of your earnings and losses in a particular year is one factor to consider.

Federal tax rates on items possibly relevant to harvesting for the 2020 tax year include: the top rate for long-term capital gains, 20%; the Medicare surtax for high-income investors, 3.8%; and the highest marginal rate for ordinary income, 37%.

Though all investors may deduct a percentage of their investment losses, these rates could make investment losses more beneficial to high-income investors.

Understand the Wash-Sale Rule

The IRS maintains the wash-sale rule, which provides that if you sell an investment to record and deduct a loss for tax reasons, you cannot purchase back the same asset—or any “substantially similar” investment asset—for 30 days.

This criterion is obvious in the case of a single stock and certain additional assets. If you incurred a loss in Exxon Mobil Corp. and wanted to recover that loss, you would have to wait 30 days before purchasing the shares again. (This requirement may actually be extended to 61 days: you must wait at least 30 days from the first purchase date to sell and realize the loss, and then wait at least 31 days before repurchasing the same asset.)

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Consider a mutual fund. If you lost money in the Vanguard 500 Index Fund, you couldn’t instantly purchase the SPDR S&P 500 ETF, which tracks the same index. You may probably invest in the Vanguard Total Stock Market Index, which monitors a different index.

Many investors employ index funds, ETFs, and sector funds to replace equities sold while adhering to the wash-sale rule. This strategy may work, but it may also fail for a variety of reasons: Excessive short-term profits in the replacement investment acquired, for example, or if the stock or fund sold increases significantly before you can repurchase it.

Furthermore, you cannot escape the wash-sale rule by reinvesting the proceeds from the sale in another account, such as an individual retirement account (IRA).

Portfolio Rebalancing

If you can do so while rebalancing your portfolio, it is one of the ideal circumstances for tax-loss harvesting. Rebalancing assists in realigning your asset portfolio to achieve a balance of return and risk. Consider which assets to acquire and sell as you rebalance, and keep the cost basis in mind (the adjusted, original purchase value).The capital gains or losses on each asset will be determined by the cost basis.

This technique will keep you from selling just to reap a tax loss, which may or may not be appropriate for your investing plan.

A Bigger Tax Bill Down the Road?

Some argue that consistently harvesting tax losses with the goal of repurchasing the sold item after the wash-sale waiting period would decrease your total cost basis and result in a higher capital gain to be paid in the future. This might be true if the investment increases over time and your capital gain becomes larger—or if you make an incorrect prediction about future capital gains tax rates.

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However, the immediate tax savings may be sufficient to balance larger capital gains afterwards. Consider the principle of present value, which states that a dollar saved in taxes now is worth more than a dollar saved tomorrow.

This is determined by a variety of variables, including inflation and future tax rates.

Capital Gains Are Not Created Equal

Short-term capital gains result from investments held for a year or less. Gains from these short positions are taxed at your regular income marginal tax rate. The Tax Cuts and Jobs Act has seven rate bands for 2020, ranging from 10% to 37% based on income and filing method.

Long-term capital gains are earnings from assets held for more than a year, and they are taxed at a much lower rate. For many investors, the rate on these profits is approximately 15% (with a few outliers, the lowest rate is zero and the highest rate is 20%). The extra 3.8% Medicare surtax applies to the highest income categories.

You should initially balance losses for a certain kind of holding against initial profits of the same type (for example, long-term gains against long-term losses).If there are insufficient long-term profits to counterbalance all long-term losses, the remaining long-term losses may be used to offset short-term gains, and vice versa.

Perhaps you had a bad year and still have losses that outweighed profits. Investment losses of up to $3,000 may be deducted against other income in a particular tax year, with the remainder carried forward to later years.

For a variety of reasons, tax-loss harvesting may or may not be the optimal option for many investors.

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The nature of your earnings and losses is certainly a factor to consider when deciding whether to harvest tax losses in a particular year. You should investigate this further or consult with your tax accountant.

Mutual Fund Distributions

With the stock market’s recent advances, several mutual funds have made substantial distributions, some of which are in the form of both long- and short-term capital gains. These distributions should also be included in your tax-loss harvesting models.

The Bottom Line

Selling an investment, even if it is losing money, for tax reasons is typically a bad idea. Nonetheless, tax-loss harvesting may be an important component of your overall financial planning and investing strategy, and it should be one of your strategies for reaching your financial objectives. Consult a financial counselor or a tax specialist if you have any queries.

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