You know the adage: “When life gives you lemons, make lemonade.” During the market downturn, we’ve been watching for opportunities to apply this wisdom to client portfolios using a practice called tax-loss harvesting. But how can taking a loss be a good thing?
As a rule, it’s not a good idea to sell investments in your portfolio and then hang out on the sidelines. However, tax-loss harvesting is one of the many tax-smart strategies we consider in a down market.
Many clients wonder what in the world we’re talking about when we suggest tax-loss harvesting. Also called tax harvesting or loss harvesting, it’s a strategy in which you intentionally sell an investment at a loss to offset current or future capital gains with capital losses. Enter the lemonade: doing this can lower your tax bill and better position your portfolio going forward.
How it works
Tax-loss harvesting generally works like this:
- You sell an investment that’s underperforming the market and losing money.
- Then, you use that loss to reduce or eliminate your taxable capital gains and potentially offset up to $3,000 in income per year.
- Finally, you reinvest the money from the sale into what is not a “substantially identical” security (per the IRS) to meet your investment needs and asset-allocation strategy.
By making this swap of holdings, your asset allocation is maintained, and you don’t miss any time out of the market.
Source: Napkin Finance ®
Rules to consider
As with any tax-related strategy, there are rules and limitations:
- The U.S. federal government allows investors to use capital losses to offset capital gains in a current tax year or carry the loss forward into future years.
- Tax-loss harvesting isn’t useful in retirement accounts.
- There are restrictions on using specific types of losses to offset certain gains.
- To ensure investors don’t get a tax break from a sale and then immediately buy back their original investment, there’s the “wash-sale rule” that applies.
If you’d like to discuss tax-loss harvesting as a tax-smart strategy for your portfolio, please reach out to your Planning team.