Don’t listen to every robo-advisor you meet: Tax-loss harvesting isn’t everything it’s cracked up to be.
If you’ve invested in the market this year, there’s a high chance you’re sitting on a few negatives in your portfolio. If you’re itching to offload that [insert latest SPAC, EV company, or weed stock], check out one strategy to lessen the sting this year.
What is tax-loss harvesting?
Tax-loss harvesting is the practice of selling investments at a loss to offset capital gain taxes from investments you sold at a gain during the same year.
Brokerage firms with robo-advisors have begun offering automatic tax-loss harvesting, romanticizing it as some opaque process that will make your capital gains taxes pull a Houdini — but that’s not quite right. Tax-loss harvesting is more about tax deferment than tax avoidance, and you’ll see why in just a sec.
People often wait ’til December to start selling off losing investments after realizing they’re in for a massive tax bill from other realized capital gains. Instead of mentioning a tax-loss harvest in your letter to Santa, let’s talk about how to keep the harvest going all year round.
As you’ll see in the example below, the most beneficial time to harvest losses is when you have a large realized short-term gain.
Example of a tax-loss harvest
Assuming your educational background included some studies in finance, we can keep this explanation top-level and mostly speaking on the tax rules around gains and losses. Like I said before, we’re taking losses you’ve realized in a stock or bond, and effectively lowering our taxable gain realized on another transaction.
- Investment A has returned a demoralizing -$8,500 and Investment B has appreciated to a $6,000 gain. You’ve held Investment A for more than a year but have held Investment B for just a few months. They’re your only two investments.
- Instead of hoping for an eventual turnaround in Investment A and risk losing gains in Investment B, you sell both.
- When you file your taxes, you’ll report your $6,000 gain and deduct $8,500 in losses. Taken together, you have a net loss of $2,500.
- You won’t owe any capital gains taxes this year, and extra $2,500 in losses can go toward lowering your taxable income (as long as it doesn’t exceed 80% of your taxable income). Had you only sold investment B at a gain, you would’ve paid $1,920 in capital gains taxes if you’re in the 32% tax bracket. ($6,000 gain ✕ 0.32)
- Any net losses that exceed $3,000 can be carried forward to future years to reduce taxable income. Since $2,500 < $3,000, we have no carryfoward.
2 situations when you might consider tax-loss harvesting
Thinking about picking up your investment gardening hoe when you encounter any of these scenarios.
Your long-term bet is lookin’ more like a short-term solution
Say that you bet big on the stock of a company that planned to start selling real estate in the metaverse for big profits. You felt like Web3 royalty for getting in so early…but you’re down 40%+ so far in 2022. Maybe that extremely long-term bet could be better suited as a short-term strategy to cut down your tax bill from stock sales?
It could be time to cut your losses if you think your investing thesis might’ve changed on your losing security. Do we have the slightest clue whose version of the metaverse is going to be the next NYC of real estate? Selling the loss hurts now, but it can be used to offset a big gain from another investment that looks to be fully valued.
Cool the cap-gains heat off your crypto
The crypto community is growing faster than the grey hairs on Charlie Munger’s head. Just like the traditional markets, there have been some winners and losers in the crypto space over the last two years. Don’t assume that stocks can only be netted with stocks; your crypto gains and losses can play a part in your tax-loss harvesting strategy.
Beware the wash-sale rule
You wouldn’t be the first person to think about selling a losing investment on Dec. 31 to get the tax break, only to repurchase it as Jenny McCarthy kisses some Times Square stranger at midnight on Jan. 1. You’d be triggering the wash-sale rule, and it’d foil your plan to lower your current-year capital gain.
A wash sale happens when you sell or trade a stock or security at a loss and purchase a “substantially identical” stock or security 30 days before or after the sale. The loss is disallowed in the current year, but it gets added to your stock’s tax basis.
…but “substantially identical” isn’t the same as similar. The loss deduction will still be allowed if you repurchase shares of a similar stock or security — say, an ETF targeting the same sector as the stock you sold at a loss.
Become a master harvester
Tax-loss harvesting exists to give us a slight cushion for taking risks. But it’s not a salve for paying your taxes; it’s just extending the due date to another point in the future. So whenever you invest, put in the time to research your investment choices…and fall back on tax-loss harvesting when you need it.