Tax Loss Harvesting for Regular Investors

Every so often, tax loss harvesting seems to show up in various marketing literature like it was just invented. The funny part is that tax loss harvesting has been around for a very long time. In fact, it’s less important today than it was before Bush the Second cut long-term capital gains tax rates to 15 percent. So, what is tax loss harvesting, and how is it important to the average investor.

Understanding Tax-Loss Harvesting and Capital Gains

tax loss harvestingTo understand tax loss harvesting, you first have to understand capital gains taxes. Income taxes apply to most forms of income. However, the profits made on the sale of certain types of investments — for our purposes, stocks, bonds and other equities — are taxed differently. These taxes are known as capital gains taxes. The easiest way to understand it by example.

If you buy $10,000 worth of Apple stock and then sell it a few years later for $20,000, then you have made a $10,000 profit. This profit is a form of income known as capital gains. The original investment amount, or purchase price, is known as the basis. The basis may be adjusted depending on several factors, but that is outside the scope of this article. You only pay taxes on the difference between the basis and the sale price. In our example, taxes are owed only on the $10,000 profit, not on the whole $20,000 sell price.

There are few important details to grasp here. First, no matter how much paper profit you have in an investment, it is not taxed until you sell. So, even when your Apple stock is worth $18,000, you owe no taxes until you sell the investment. Note this is different from the dividends the stock pays, which are taxable in the year they are paid, even if you reinvest them. Dividends cannot be offset using tax-loss harvesting.

Capital gains are taxed at one of two rates. If you hold the investment for less than one year, this is called a short-term capital gain. Short-term capital gains are taxed as ordinary income. In other words, if you are in the 30% tax bracket, you would pay taxes at the 30 percent rate.

If you hold the investment for longer than one year, then it is a long-term capital gain. Long-term capital gains are taxed at a fixed rate of 15%. (Technically, it can be lower for certain lower incomes.) This is how wealthy people pay such a low tax percentage. If most your income comes from investments, then most of your income is taxed at 15 percent, no matter how high your income actually is.

The final thing to understand about capital gains before you can understand tax-loss harvesting is that you can offset capital gains income with capital losses of the same type. Again, and example is the quickest way to understand.

Let’s say that you make that $10,000 profit on your Apple investment. Now, let’s say, that in the same year you sell your Dubious Company stock. If you bought Dubious Co. at $20,000 and your holdings are worth $12,000 when you sell, you have lost $8,000. That amount is a capital loss.

Now, you can offset that $10,000 capital gain with the $8,000 capital loss, and now you will only owe taxes on $2,000 of capital gains.

Tax Loss Harvesting Defined

So, what exactly is tax-loss harvesting? In the example above you happen to have $8,000 of losses to offset your $10,000 in gains. If you did that intentionally, specifically for the purpose of generating a loss to use to offset your gains, then that is tax-loss harvesting.

Generating losses in order to offset gains is tax-loss harvesting. IRS rules prevent you from buying an investment that is substantially the same for 30 days. In other words, you can’t sell IBM shares, and then buy back those shares withing 30 days, or the loss doesn’t count. This is called a wash sale and is disallowed as a capital loss.

That’s it. That’s all it is.

However, most investment advisors, or financial planners add the next step, which is to buy a replacement investment that is similar enough to the same to keep your portfolio invested like it was before you sold something for a loss, without triggering the wash sale rules. This is very easy with mutual funds or ETFs, and pretty easy with most stocks, assuming that you are managing your portfolio as a whole.

Who Needs Tax-Loss Harvesting

Now we are ready to really understand tax-loss harvesting and how it works, and why it sounds so great on paper, at least.

Individual Stocks

If you only own stocks that you want to own because you have done your research, and you really believe in those specific companies, then tax-loss harvesting probably may not make much sense at first. If you really believe in Yahoo stock, then selling it for tax purposes doesn’t make sense. (In fact, many financial experts advise clients to ignore tax ramifications and just do what is right for your money while letting the tax chips fall where they may.) The reality is that unless something major happens during those 30 days, the price likely won’t have moved that far from your sell price.

Most professional tax-loss harvesting happens away from a company’s earnings announcements for this reason. You won’t want to not own your shares of Yahoo when the company announces it tripled its profits. In fact, if you ever notice your financial advisor harvesting tax losses at earnings time, you may question their competency.

Mutual Funds and ETFs

The easiest tax-loss harvesting is on mutual funds or exchange-traded funds. It is very easy to replace most funds or ETFs with something similar. In fact, with index funds, it is very, very easy. Even for tax purposes, a Vanguard S&P 500 index fund is not the same thing as a Fidelity S&P 500 index fund. So, if you have a loss on one, you can sell it, bank the loss, and then buy a different fund, or better yet, an S&P 500 ETF. You still have essentially the same investing exposure during those 30 days.

Do You Really Need Tax-Loss Harvesting?

As with many financial services and products, the science and finance behind tax-loss harvesting is legitimate. However, that doesn’t mean that is is useful or helpful for all investors. In many cases, it is nothing more than a gimmick, a way to make one investment advisor or another seem special, and not something that will actually help your finances.

When Tax-Loss Harvesting is Not Worth It

You do NOT need tax-loss harvesting in non-taxable accounts, because you do not pay capital gains taxes on those funds, ever. This should go without saying, and very often, it does. If your investment portfolio mainly consists of an $800,000 401k rollover account, tax-loss harvesting is not useful for you.

Commissions and fees can be generated by the selling and buying of investments to generate tax-losses to harvest. This makes tax-loss harvesting a losing proposition for most accounts where you pay a commission, a mutual fund load, or other fee. This is especially important to watch for with mutual funds.  Always get the full cost of the transaction in writing ahead of time. Remember to compare it not to the amount of the loss, but the amount of the tax it will save (roughly, 15% of the total loss.)

For example, if you have a $50,000 investment in a mutual fund that you can sell to generate a $10,000 loss, the the tax savings is roughly $1,500. If you have to pay a 3% load to buy your similar mutual fund, you’ll pay $1,500. In other words, you won’t actually save any money. In general, then tax-loss harvesting works best for people paying a deep discount commission on trades (like those $11.95 trades), or for those who pay an annual fee. If you are paying 1% of your total investment portfolio (and no trading charges) then the cost does not change.

Another factor is that in order for tax-loss harvesting to be worth it is that you have to have enough losses, and enough gains.

Remember capital gains losses can only be used to offset capital gains, except for $3,000 worth. In other words, if you have $20,000 of losses an no capital gains, you can only deduct the $3,000 in that year. While you can carry forward losses to future years, you need to decide if the future possibility of a tax offset is worth the expense and effort now. Even if you have a lot of taxable money invested, if you aren’t selling you aren’t generating gains, and those losses aren’t necessary.

As always, remember to calculate not only the percentage, but the real dollar amount. Tax-loss harvesting isn’t usually worth it until you are talking about a taxable invested portfolio of well over $100,000, with gains over $10,000. (Remember, your 401k and IRAs are already immune from capital gains, so don’t count them.)

In the end, tax-loss harvesting isn’t for basic investors with less than at least six-figures in taxable investment, except in extreme cases. If your advisor is pushing the concept for you ask him to compute a dollar amount (not a percentage) and see if its really worth it in your case.

If you do have a large portfolio and your capital gains taxes are taking a bite, then do check with your advisor to see what they are (or are not) doing about harvesting tax losses for you.

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