In the investing world, how can it be possible to win even when you lose?
That is precisely what occurs when utilizing a tax loss harvesting strategy. The U.S. federal income tax law allows realized capital losses to offset capital gains, along with a limited amount of ordinary income that would otherwise be taxable. There’s a lot to unpack related to tax loss harvesting, so let’s take it one aspect at a time.
Realized capital loss simply refers to an investment which is sold after depreciating in value. For example, if I bought a stock position for $100 and it is now worth $90, I would realize $10 of capital loss if I sold it. Before the sale, the $10 would be considered a paper loss, because the loss has only occurred on paper. Does this mean that we should avoid selling so that we don’t lock in or realize the loss of money? Not at all! The loss has already occurred, whether we sell or not. But we can win even when we lose if we utilize the tax code to reduce our tax burden for the current tax year.
Where tax loss harvesting shines
When selling a position to capture capital loss you can reinvest the proceeds in a different position which is similar, but not identical. This reduces your tax burden for the current tax year while still maintaining a similar risk and return experience. At year end, you can then net any realized capital losses against all capital gains realized from the current year. If the losses are larger than the gains, not only will you owe no tax on capital gains, but also you could use the remaining capital losses to offset up to $3,000 of your ordinary taxable income. Any additional capital losses remaining will carry forward into future tax years, until you fully exhaust the losses in that same way on an annual basis.
Clients will often ask, “If tax loss harvesting occurs, does that mean my portfolio has lost value?” The answer is: not necessarily. It’s quite common to see certain asset classes fall in value, while others in the portfolio continue to grow in value, leading to a higher overall portfolio value. This allows investors to harvest losses on positions which have fallen in value while retaining the positions which have grown in value.
In some circumstances where offsetting future capital gains is a high priority, you can achieve a more advanced version of tax loss harvesting through a separately managed account, or SMA for short.
Separately Managed Accounts
You can utilize an SMA when you anticipate a large tax bill upcoming from the sale of a farm or business. Or, some clients who need to bank a lot of capital losses to offset gains in the near term. Instead of investing in a single fund which targets the S&P 500 index, an SMA allows you to invest in something closer to all 500 of the positions in the index. To illustrate the effectiveness of an SMA, recall that the value of the S&P 500 increased 11.7% in the fourth quarter of 2023. But in that same fourth quarter, 178 of the 500 individual companies saw their stock prices decline. This means that there were 178 opportunities to capture capital losses while the total portfolio would have still gained 11.7% over that period! While there are downsides to employing an SMA, such as increased costs and the potential complexity of unwinding the strategy in the future, the benefits often outweigh the costs for those with large and imminent tax bills.
Negatives of Tax Loss Harvesting
With all the benefits of tax loss harvesting, why shouldn’t every client employ this strategy? Tax loss harvesting is not a magic trick which eliminates the gains forever. It is a tax deferral strategy where the taxes are likely to be paid in future years, instead of the current year. While it’s true that this kind of successful financial planning can lead to lower total taxes being owed, in some instances tax loss harvesting can lead to a greater tax burden if the future additional gain recognition occurs in a year with higher income and, consequently, a higher tax bracket. Clients in the lowest tax brackets may often have a 0% tax rate on capital gains. For them, tax loss harvesting may lead to the unintended consequence of a larger tax burden in the future. Ideally, tax loss harvesting is a strategy for those in the higher tax brackets who expect to be in a lower tax bracket in the future.
Ramifications of buying into a position which isn’t your preferred security during the tax loss harvest process can present other negatives. In realizing losses for tax purposes, a common practice is to sell your current preferred position, move into a replacement security or fund for 30 days, and then move back into your preferred position. However, if the market runs up during this 30 day period, it may be unwise to sell the replacement security or fund and return to the original position due to the gains now associated with the replacement position. The implication of remaining in the replacement security or fund could result in a lesser return, which could diminish or erase the value of the tax loss harvest process.
At Foster Group, truly caring for our clients means taking the time to learn what’s in their hearts and helping them pursue their goals. Tax loss harvesting can be a powerful planning tool that leads to greater wealth in the long run. However, it also can be more complicated, with unintended consequences that may be detrimental to your overall financial plan. Because Foster Group is not a tax advisor, we always recommend consulting with your tax professional before making any decisions with possible tax ramifications. We have spent a considerable amount of time refining our tax loss harvesting process and parameters, so if you have any questions or would like to discuss this strategy further, please be sure to contact us!
