Making Lemonade: Tax-Loss Harvesting
In ranching country, experienced livestock raisers know that periods of drought are inevitable. Not only that, but they know that there are certain things that need to be done during the dry times in order to be able to take maximum advantage of the rains when they begin to fall again in the future. Knowledgeable ranchers will utilize drought cycles to make sure their water reservoirs are in good shape; sometimes they will dig new ones. They’ll give special attention to their pasturing plan, being certain to make maximum use of their available resources in order to keep their pastures healthy and ready for the next rains.
In many ways, a down market is the same for investors. No one enjoys watching the value of their portfolio drop, but at the same time, experienced investors know that markets don’t always go up—though, historically, they tend to go up more often than they go down, which is a good thing! During down market cycles, there are things you can do to prepare for the next upswing, and one of the most important preparations you can make is tax-loss harvesting.
First, it’s important to remember that in tax-loss harvesting, we are considering two main types of taxes: long-term capital gains and short-term capital gains. Long-term capital gains are taxed at one of three rates, depending on your other income: 0%, 15%, or 20%. Especially for higher-income individuals, even the maximum capital-gains tax rate is typically less than the tax rate for ordinary income. Long-term capital gains taxes apply to gains on assets held for a year or more. Gains on assets held for less than a year are subject to the short-term capital gains tax rates, which are the same as the taxpayer’s ordinary income tax rate.
Suppose you have sold Mutual Fund A, which you owned for over a year, and you realized a capital gain on the sale of $150,000. If you do nothing, you will pay tax on that gain at whatever long-term capital gains tax rate applies to your income bracket (likely either 15% or 20%). However, if you have Mutual Fund B, also held for over a year, which has an unrealized capital loss of $75,000, you might wish to “harvest” that loss and use it to offset the gain in Fund A, cutting in half the amount of your taxable long-term capital gain. That, in its simplest form, is how tax-loss harvesting works.
Often, investors who employ tax-loss harvesting will want to replace the asset that they sold at a loss, in order to maintain their desired asset allocation. But you must wait at least 30 days after a sale before replacing the asset with another that is “substantially identical,” in IRS terminology, in order for the loss to be recognized (this is referred to as the “wash sale rule”).
Short-term capital losses may also be used to offset gains, but they must first be allocated against short-term gains, if any. Net short-term losses may then be applied to offset long-term gains. The vice-versa is also true: long-term losses can be used to offset short-term gains, but only after they have been applied to any long-term gains.
This is where tax-loss harvesting offers its biggest benefit. Later, when the market recovers and resumes its upward trajectory—which we believe it will—you are likely to have gains. When the time comes that the portfolio needs to be rebalanced, the sale of assets will likely be required, many of which could generate capital gains, which usually means writing a big check to the IRS. But with prior tax-loss harvesting, many of those gains can be offset, alleviating or greatly reducing the investor’s tax bill on realized gains.
Another benefit from tax-loss harvesting is that if in a given year you aren’t able to utilize all your losses against capital gains, you can carry them forward to offset up to $3,000 of ordinary income or investment gains for a future tax year. This helps prevent a “use it or lose it” scenario.
At Bernhardt Wealth Management, we are committed to our clients’ best interests in every situation. This includes providing guidance on the most tax-efficient ways to manage their portfolios. We want our clients to take maximum advantage of the “drought cycle” so that they can better benefit when the “rains of profit” begin to fall again. To learn more, click here to read our article, “The Fed, the Economy, and the Financial Markets.”