“Good news, we have some losses!” That is not exactly what you want to hear from your financial planner and investment advisor. We all know that the stock market goes up and down, and that means that sometimes you can have some losses. But the good news is that, with proper planning, we can take advantage of those losses in your taxable (non-retirement) accounts to help you save some tax dollars right now.
First, it’s important to understand that when discussing tax-loss harvesting, we are considering taxes on two main types of income: long-term capital gains and short-term capital gains. For the tax year 2024, long-term capital gains are taxed at one of three rates, depending on your other income: 0%, 15%, or 20%. Especially for higher-income individuals, even the maximum capital-gains tax rate is typically less than the tax rate for ordinary income. Long-term capital gains taxes apply to gains on assets held for a year or more. Gains on assets held for less than a year are subject to the short-term capital gains tax rates, which are the same as the taxpayer’s ordinary income tax rate. When we talk about stock sales, we frequently refer to “realized” or “unrealized” gains. You “realize” a gain or loss when you actually sell a stock. Before you sell it, that gain or loss is called “unrealized”.
So, how does it work? Well, suppose you have sold Mutual Fund A, which you owned for over a year, and you realized a capital gain on the sale of $150,000. If you do nothing, you will pay tax on that gain at whatever long-term capital gains tax rate applies to your income bracket (likely either 15% or 20%). However, if you have Mutual Fund B, also held for over a year, which has an unrealized capital loss of $75,000, you might wish to “harvest” that loss by selling Fund B and use it to offset the gain in Fund A, cutting in half the amount of your taxable long-term capital gain. That, in its simplest form, is how tax-loss harvesting works.
Sometimes, investors who employ tax-loss harvesting will want to replace the asset that they sold at a loss in order to maintain their desired asset allocation. But you must wait at least 30 days after a sale before replacing the asset with another that is “substantially identical,” in IRS terminology, in order for the loss to be recognized (this is referred to as the “wash sale rule”).
Short-term capital losses may also be used to offset gains, but they must first be allocated against short-term gains, if any. Net short-term losses may then be applied to offset long-term gains. The vice-versa is also true: long-term losses can be used to offset short-term gains, but only after they have been applied to any long-term gains.
This is where tax-loss harvesting offers its biggest benefit. Later, when the market recovers and resumes its upward trajectory—which, historically, it typically has—you may have gains. When the time comes that the portfolio needs to be rebalanced, the sale of assets will likely be required, many of which could generate capital gains, which usually means writing a big check to the IRS. But with prior tax-loss harvesting, many of those gains can be offset, alleviating or greatly reducing the investor’s tax bill on realized gains.
Another benefit from tax-loss harvesting is that if, in a given year, you aren’t able to utilize all your losses against capital gains, you can carry them forward to offset ordinary income or investment gains for a future tax year. This can help prevent a “use it or lose it” scenario.
At The Planning Center, we want to help our clients make smart decisions that allow their investments to work as hard and efficiently as possible. Tax efficiency is a big part of that equation, and under the right circumstances, tax-loss harvesting can help investors save on taxes while also keeping their portfolios properly positioned for their individual goals and circumstances. If you have questions about tax-loss harvesting or any other important financial matter, please call us. And to learn more about how we help clients manage their investments to achieve their goals, please visit our website.
