Pros and Cons of Tax-Loss Harvesting
Successfully managing wealth in the stock market is much more than just making the right stock or ETF selection. It requires a thorough understanding of the current market conditions in which an investor is operating; it demands one to not only keep up with the everchanging world, but also seek out opportunities outside of the stock market to attain an edge over the street and optimize performance. Most investors are cognizant of the tax implications of their trades, but the best take it a step further by selectively capitalizing on opportunities when they present themselves.
Market downturns are an inevitable reality of investing. Unfortunately, nearly every investment will perform poorly at one point or another. When this happens, savvy investors know if carefully calculated and executed, tax-loss harvesting can be a silver lining. Tax-loss harvesting, or tax-loss selling, is a method of selling an investment at a loss in order to reduce taxable capital gains and potentially offset up to $3,000 of ordinary income, depending upon your tax filing status. When a portfolio is managed to a model, generally the proceeds from the sale are reinvested into a different security that meets the model’s requirement and asset-allocation without violating the IRS rule against buying a “substantially identical” investment within 30 days (i.e., wash-sale rule).
For example, let’s say you sell a stock you bought less than a year ago for a short-term gain of $40,000. At the same time, you sell shares of another stock for a short-term loss of $60,000. For federal income tax purposes, the $60,000 loss will offset the $40,000 gain, meaning you will owe no taxes on the gain, and you can use the remaining $20,000 loss to offset up to $3,000 of ordinary income. The remaining $17,000 loss can be carried forward to offset capital gains and ordinary income in future tax years. For the purpose of this example, assuming you fall into the 32% tax bracket for short-term gains and ordinary income, the immediate tax benefit of harvesting the loss to offset the gain can be as much as $13,760. It is important to note that tax-loss harvesting only works on taxable investments. Many retirements accounts, such as IRAs and 401(k) accounts, are tax-deferred and therefore do not allow investors to offset taxable gains to take advantage of tax-loss harvesting strategies.
While tax-loss harvesting can be a silver lining to a down market and a beneficial investment approach, it is critical to not let the tax tail wag the investment dog. It is easy for over-zealous investors or financial advisers to focus on the tax aspect of the investment process but doing so can have unintended consequences. One of the main pitfalls of tax-loss harvesting is it drives your cost basis lower and can result in a large capital gain in the future; meaning it can lead to a bigger tax bill down the road overshadowing the immediate benefit it can provide.
Consider this example: You bought 1,000 shares of Apple for $160,000 ($160 per share). Two years later, Apple is trading at $140 per share, which means your initial investment of $160,000 is now worth $140,000. To take advantage of tax-loss harvesting, you sell your shares of Apple at $140 per share, buy it back after 30 days (avoiding a wash-sale) at $140 per share and see tax benefits this year related to the loss. Some years in the future, Apple is trading at $200 per share, and you sell your investment to realize a long-term gain of $60,000. Assuming your long-term gains are taxed at a 20% rate, and you do not have any losses to offset, you will owe the IRS $12,000 relating to the capital gain. However, if you had not previously utilized tax-loss harvesting, you would owe only $8,000. In other words, you now owe $4,000 in additional taxes because of your pervious decision to tax-loss harvest. One can argue, however, that this is not necessarily a bad thing, since you could have used the $20,000 loss from your initial trade to offset capital gains and ordinary income in that year and in future years. Nevertheless, tax-loss harvesting lowers your cost basis and its ultimate benefit depends on other tax-related matters, such as the level of realized gains or losses, your tax bracket, as well as state income tax rules.
Another potential downside of tax-loss harvesting is that it can throw off your asset allocation. At a model level, when a portfolio manager considers tax-loss harvesting he/she will need an alternative or a replacement security to hold that is not substantially identical to the original security; more often than not, cash is not an appropriate asset class to meet the allocation requirement and provide the proper type of market exposure. Attempting to tax-loss harvest without a proper alternative in place to meet the risk/reward exposure requirements can undermine a strategy’s performance, particularly in volatile market.
Tax-loss harvesting can be a great strategy to reduce tax liabilities. However, it is vital to understand that not every losing position is a good candidate for a tax-loss opportunity. Tax-loss harvesting is an effective investment tool as long as it is applied correctly in the appropriate situations.
Thomas Nuzzi
Equity Trader
Disclosures:
This is provided for informational purposes only and should not be interpreted in any way as investment, tax, accounting, legal or regulatory advice. An investor must take into consideration his/her individual circumstances.
There is no guarantee investment strategies will be successful. Investing involves risks including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. All expressions of opinion are subject to change. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investors should talk to their wealth advisor prior to making any investment decision.
