Tax-Loss Harvesting: How to make lemonade out of market lemons
In March, we discussed 10 financial moves you can make in the midst of uncertain times. Today, we want to dig deeper into #8 on that list: Tax-loss harvesting. If you’re not a hands-on investor, you might not know much about this strategy, but it can be a powerful tool to boost your long-term returns during short-term market dips.
Tax-loss harvesting essentially works like an anti-gravity suit: When the market goes down, you can capture your losses to offset your future gains and significantly lower your tax bills. It’s the one time you want to sell low, not high!
When done wisely, researchers estimate tax-loss harvesting has the potential to boost after-tax returns 1% annually over time. Tax-loss harvesting can also be an especially relevant strategy if you are anticipating big gains over the next several years, such as a real estate sale, business sale or other appreciated stock sale. It is an important part of a thoughtful long-term investment plan—one that’s built on patience and flexibility.
Here’s how tax-loss harvesting works:
- We identify a security in your brokerage account that is currently worth less than what you paid for it. We are usually looking for stocks that are at least $1,000 below their cost basis. We sell the stock at a loss.
- We buy a similar security that is also trending low to rebalance your portfolio. We choose something that we believe will do well over time. We want to make sure we’re not missing out when the market swings back up! It’s important that we choose a replacement that doesn’t rely on the same holdings or use the same index as the stock we sold. The IRS’s “wash-sale rule” prohibits writing off losses if you purchase a “substantially identical” security within the next 30 days.
- We make sure to turn off automatic dividend reinvestments on the stock we just sold. If those automatic reinvestments go through, they can trigger the wash-sale rule by technically purchasing the same stock within that 30-day window—even if we didn’t mean to!
- We will record the loss from the stock sale on your tax return and use it to cancel out your capital gains. If your losses exceed your gains, you can deduct up to $3,000 per year. Any losses over that $3,000 amount can be carried forward year to year, until you’ve used it all up. Because of this, you can “bank” a loss from one year to help offset future gains down the road.
We took advantage of “The Covid Canyon” in the spring of 2020 to harvest significant losses that have been offsetting our clients’ gains ever since. It’s one way to make lemonade when the market throws you lemons! A strong tax-loss harvesting strategy can reduce your taxes in the near-term and help you retain more of your long-term investment dollars.
Because of the intricacies of the wash-sale rule, transaction costs, and other trading details, we recommend that people have a trusted advisor handle their tax loss harvesting. Want to know if this strategy is right for you? Let’s set up a time to talk.
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