One of the ways we help clients maximize their investment returns is by remaining vigilant for tax-loss harvesting opportunities during market declines. Like a silver lining in cloudy conditions, tax-loss harvesting can save you a significant amount of your own silver when the tax bills come due. On the other hand, like any good tool, in the wrong hands, it can cause harm instead of good. Let’s take a look.
An Advantageous Overview
First, what is tax-loss harvesting? It’s a technique for generating a legitimate capital loss on paper that you can use to offset current or future taxable capital gains … without actually losing the money permanently.
How does it work? Well, that’s where your fee-only financial advisor can be helpful, because the devil’s in the details. But, big picture, you sell a holding for which you’ve experienced a capital loss, temporarily purchase a similar but substantively different holding for no less than 31 days, and then buy back your original holding. After all the buying and selling dust has settled, it’s as if you never sold anything, and your investment position is unchanged. But you’ve got a legitimate capital loss you can use to reduce your capital gains taxes. (This is assuming all the trading is going on within your taxable accounts – losses in IRAs aren’t tax deductible.)
If your head’s swimming by now, an illustration might help. Imagine you hold a mutual fund of U.S. large-cap growth stocks that have been doing poorly this year, so your original $100,000 investment is now worth only $80,000 on paper. Here’s the harvest:
- Sell the fund, and you’ve just realized a $20,000 capital loss.
- Use the $80,000 sale proceeds to buy, say, an S&P 500 Index fund for just over a month, so you’re not out of the market entirely.
- Hold the replacement fund for at least 31 days. When the time is up, you can sell it and buy back the original fund.
Afterward, you’re still holding the same carefully selected long-term investments you had to begin with, but you’ve produced some income tax savings for nothing more than the cost of a couple of trades.
Before you start running with harvesting scissors, be aware that there are some unpleasant traps for the unwary.
One trap can and should be avoided; that’s the “wash sale rule,” which the IRS uses to determine whether your tax loss is legitimate. Two main clauses of this rule dictate: (1) how long your interim period must be (thus the 31-day wait), and (2) what types of replacement holdings you can purchase during your interim period. The replacement holding can be similar, but not “substantially identical,” and believe me, there’s a fine line between these definitions. Violate the wash sale rule, and you’ve just spent good money making pointless trades, plus you’ve annoyed the IRS. That’s never a good idea!
Another trap is beyond anyone’s control: the whims of our unpredictable markets. In our illustration above, we assumed that prices for both original and replacement funds cooperated nicely by remaining level during the 31-day waiting period. In that case, you receive the full benefit of your harvesting efforts. But what if the market doesn’t play so nice? What if the value of your original fund soars over that month, while the value of the replacement fund dips? When you unwind the trade after 31 days, you could have a loss. The replacement fund must be chosen with care to maximize the chance that its performance will be similar to the original fund.
And keep in mind that if the market soars during the 31 days, when you unwind the tax-loss harvesting transaction, you may incur a nasty short-term capital gain when you sell the replacement investment and buy back your original holding. The resulting gain could wipe out the advantage of the loss, or worst-case, incur more taxes than you would have had to begin with.
Look Before You Leap
Thus it’s important to be thoroughly familiar with wash sale rules, as well as acutely aware of the level of risks involved in any particular harvest. While we’re on regular look-out for tax-loss harvesting opportunities for our clients — and this year was no exception — we certainly don’t execute them every time. First, we consider the magnitude of the opportunity in relation to its transaction costs, available investment alternatives and other factors. Only when the circumstances seem comfortably in our clients’ favor do we leap.