Year-end is a good time to review your tax situation and consider making moves to reduce your 2022 tax liability prior to the end of the year. One strategy to consider is tax-loss harvesting.
What is tax-loss harvesting?
Tony May, Managing Director, Investments of the Wedbush Securities Newport Beach office says, “Tax-loss harvesting can be an effective strategy to offset capital gains and potentially increase portfolio performance. By capturing the loss of an investment(s), you not only mitigate capital gains, but you can also reinvest the proceeds in another investment that has the potential to perform better.”
May adds, “Moreover, if you think the investment(s) that you sold has long term potential, you may get a chance to buy it back at a cheaper price. However, you must wait 31 days to avoid the wash-sale rule.”
Tax-loss harvesting is a tactic where an investor sells an investment at a loss and uses that loss to offset capital gains on other investments where gains have been realized during the year. Stocks, bonds, ETFs, mutual funds and other investments can be employed in implementing tax-loss harvesting.
Benefits of Tax-Loss Harvesting
Realizing tax losses on investments in taxable accounts allows an investor to reduce their tax obligation on long-term capital gains which are taxed at a preferential rate, or on short-term capital gains that are taxed as ordinary income. This can lower your overall tax bill. Any tax-losses that exceed the amount of short and long-term capital gains can be used to offset other income up to $3,000. Any remaining losses can be carried over to a subsequent tax year and used to reduce capital gains and/or up to $3,000 in other income.
The ability to use tax losses to reduce the net level of capital gains can be useful in positioning your portfolio to stay aligned with your long-term investment strategy. Rebalancing is an important part of managing your investments. Tax-loss harvesting can fit in nicely with the rebalancing process.
Deborah Stokes, Financial Advisor of Wedbush Securities Independent Franchise Owner Network says, “Despite the equity market downturn, many mutual funds will be making year-end capital gain distributions. Estimates are available – good time to review and strategize tax-loss selling to offset planned December distributions. Losses are applied first to any gains. Excess losses can be used to offset ordinary income, subject to annual limitations.”
Stokes adds, “With rates rising, bond values have dropped. Consider selling lower coupon municipal bonds to harvest losses, creating opportunities to reinvest in higher coupons.”
Considerations for using tax-loss harvesting
Tax considerations should not be the driving force in making an investment decision, so tax-loss harvesting should not be used unless it fits in with your overall investment strategy.
Tax-loss harvesting can only be used in taxable investment accounts. This tactic is not applicable to tax-advantaged retirement accounts like an IRA or 401(k). This includes both traditional and Roth accounts.
There is an ordering rule in tax-loss harvesting between long-term and short-term capital gains and losses. Long-term losses are first used to offset long-term capital gains. Short-term losses are first used to offset short-term gains. Any remaining losses are then used to offset any remaining gains of either type.
One important aspect of tax-loss harvesting that investors must be cognizant of is the wash-sale rule. The rule places limits on when an investor can purchase the same or similar security as the one that was sold to be used for tax-loss harvesting.
The wash-sale rule says that you cannot purchase the same or a similar security within a 61 day period from the time of the sale. The period extends both 30 days prior to and 30 days after the sale date, plus the actual date of the sale transaction. This rule not only includes purchases that might be made in the same account, but it extends to all accounts, including retirement accounts such as an IRA or 401(k) account.
The same security is pretty straightforward. If you were to sell shares of a specific stock at a loss, you could not purchase shares of this same stock in any account during the wash-sale period. Doing so would negate the ability to use the loss realized on those shares.
When it comes to a similar security, sometimes this is clear and sometimes it is not. For example, if you sold shares of fund company A’s S&P 500 index fund at a loss, you could not purchase shares of fund company B’s S&P 500 index fund. Where it can get muddled is if you were to sell shares of an ETF that tracks a large cap growth index and purchased shares of an ETF that tracks a completely different large cap growth index. In these cases, it makes sense to consult with your tax advisor or a knowledgeable financial advisor.
To determine if tax-loss harvesting or other tax-efficient strategies make sense for you, please consult with your Wedbush financial advisor.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.