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Tax-loss harvesting can be valuable, potentially significantly so, to the right investor.
This is the takeaway from a recent study released by Vanguard. The firm looked at the practice of tax-loss harvesting (TLH) to determine when this practice is most useful for an investor’s portfolio. Specifically, the authors analyzed how this can help maximize a portfolio’s value for minimal cost. The value, they found, can vary significantly, but it can be quite useful based on the situation.
They found that for the right investors, tax-loss harvesting can potentially boost a portfolio’s value by anywhere from around 0.5% to around 4% over the long run. The most likely value is around a 1% increase in overall portfolio gains.
As we start to wind down 2024, with only a few weeks left to manage your annual capital gains, here’s what you should know. Consider speaking with a financial advisor about your own tax strategy.
Tax-loss harvesting is the practice of selling assets in your portfolio for a capital loss in order to reduce your overall taxable earnings, either capital gains or income. Typically, in this practice, an investor will then reinvest the money from the sale in a broadly similar asset or asset class. The result is an overall tax reduction that allows you to maintain your target asset allocation.
You can offset capital gains by any amount of capital losses you took during the same year. In most cases there is no limit to this practice, allowing you to reduce your taxable gains down to zero if you had equivalent losses. You can also offset up to $3,000 of earned income annually with capital losses. In order to do this, you must have no remaining taxable capital gains for the year (either no gains at all, or no remaining gains after offsetting losses).
For example, say that you earned $75,000 this year. This would give you federal taxes of around $8,761. However, say that you also have shares of stock in ABC Co. that are steadily losing value. You sell those shares for $5,000, posting a $2,500 loss from when you first purchased them. This gives you a capital loss of $2,500.
You can use this harvested loss to offset some of your taxable income, reducing it to $72,500. This would reduce your federal taxes to around $8,211, saving you about $550 in taxes. You can then take both the $5,000 proceeds from your stock sale and your $550 in tax savings and reinvest the total $5,550 in a company with a profile similar to ABC Co., but one that might perform better in the long run. This allows you to keep your desired asset classes, ditch a value-losing investment and reduce your taxes all in the same transaction.
Note – It is important that the reinvestment assets are not specifically similar. The Wash Sale Rule bans the practice of harvesting tax losses then purchasing assets that behave substantially identically within 30 days. The purpose of this rule is to prevent you from repurchasing the same asset. This does not prohibit you from buying generally similar asset classes like another stock or bond, but it may prohibit you from reinvesting in certain funds.
Joe Schmitz, Founder of Peak Retirement Planning, Inc., said tax-loss harvesting “can be a powerful strategy to reduce the amount of capital gains you will owe in your brokerage account. This is especially valuable when if you have major gains in your brokerage account as well as major losses.”
However, Schmitz noted, a tax-loss harvesting strategy doesn’t work for every investor. “If you are a buy and hold investor,” he noted, “it may not always be the best play, as you would be selling stocks low rather than allowing them to recover. But if your goal is to sell something low to offset something that is high, this could save some significant money in taxes.”
Schmitz’s comments address the core of Vanguard’s findings. A tax-loss harvesting strategy will not work for every investor, but it can be very valuable for the right profiles. You can use this free tool to match with a financial advisor if you’re interested in personalized guidance.
Tax-loss harvesting does not work for every portfolio.
Most notably, this is not typically a strong approach for long-term buy-and-hold portfolios like most retirement accounts. In fact, this approach also has no value for untaxed retirement portfolios like Roth IRAs. Long-term portfolios typically rely on a plan of recovered value, meaning that your goal is to leave assets in place to recover their value after a loss. Active tax-loss harvesting in a long-term portfolio can reduce or even eliminate those potential gains.
Instead, Vanguard identified three specific factors that drive value for a tax-loss harvesting strategy. They are:
This category refers to the ability for your portfolio to generate losses that you can harvest for tax savings. This category generates about 31% of the gains from a TLH strategy. Most of the value from this category comes from your portfolio’s exposure to volatility, trading frequency and the nature of the assets you hold in the portfolio.
This category is defined by investor characteristics. Your portfolio’s ability to generate losses is based on how you have structured it, and how you conduct your trading. If you are a frequent trader, for example, you will have more opportunities to spot opportunities for loss harvesting. If you hold individual or more granular assets, they are often more volatile and therefore more likely to offer opportunities for loss.
In total, as Vanguard notes, loss generation is one of the three crucial elements to a tax-loss harvesting strategy. You need to take losses in order to harvest them, and those losses are defined by your investor and portfolio profiles.
This category refers to your ability to save a meaningful amount of money on your taxes from loss harvesting. It drives about 32% of the value of a tax-loss harvesting strategy. This category is generally defined by your taxes and tax brackets.
This is your investor decision bracket, because it’s defined by how you have chosen to structure your gains and taxes. If you have significant capital gains in a year, you can harvest greater losses because capital gains can be offset entirely by losses. If you do not have capital gains, you can only harvest losses up to $3,000 to offset your income. Also, the higher your current tax rate, the more money you will save through loss harvesting.
Just as importantly, the more of your tax savings you choose to reinvest, the more long-term gains you will see.
This category refers to the performance of your portfolio and your reinvestments. It accounts for about 37% of the value of a tax-loss harvesting strategy. This is also the market factor category, as it primarily refers to issues outside of the investor’s control.
Specifically, the value of your reinvested tax savings is based on the market returns on your new investments. If those investments perform well, your capitalization of the TLH strategy will have greater value.
What does this mean for you?
Vanguard found that the value of a tax-loss harvesting strategy, more than anything else, depends on whether investors are disciplined about reinvesting their tax savings. It also depends significantly on their tax rates. These two factors work together: higher tax rates mean more savings, which means more reinvestment.
By contrast, lower tax rates reduce the value of a tax-loss harvesting strategy, potentially all the way down to zero. It’s important to understand that risk.
For example, say that you are an individual who sells $30,000 worth of stocks, with $15,000 in other income that year. This income level puts you in the 0% capital gains bracket, meaning that you would see no tax benefits from offsetting these gains. You would need to take capital losses worth $33,000 in order to entirely offset your gains and then the annual maximum of $3,000 worth of income before you could see a benefit to tax-loss harvesting that year (note that capital losses can be carried forward into future years if in excess of $3,000).
The upshot is that tax-loss harvesting can have real value for your portfolio, in the right situation. Don’t sell valuable assets at a loss just in the hopes of some tax savings. Make sure that this really is an asset you want to sell. Then, wait for the right opportunity. This can be valuable – for the right profile. Talk to a financial advisor if you’re interested in evaluating your investment and tax strategy.
Tax-loss harvesting is the practice of selling assets at a loss to save money on your taxes. As Vanguard explains, if you reinvest these savings into your portfolio this practice can be a powerful moneymaker.
A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Keep an emergency fund on hand in case you run into unexpected expenses. An emergency fund should be liquid — in an account that isn’t at risk of significant fluctuation like the stock market. The tradeoff is that the value of liquid cash can be eroded by inflation. But a high-interest account allows you to earn compound interest. Compare savings accounts from these banks.
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