Smart Tax Planning: A Primer on Tax Loss Harvesting
A key element to the effective management of your taxable investment portfolio is the implementation of “tax loss harvest” opportunities. While we know it is harvest time here in Central Illinois, this strategy has nothing to do with corn and beans and everything to do with your income taxes. We thought we’d take a moment to highlight exactly what it is and how it is of benefit to you and your long-term wealth management plan.
What is tax loss harvesting?
Tax loss harvesting is a strategy used to potentially lower or defer tax bills by realizing losses on certain investments and utilizing those losses to offset gains or income in other areas of an investment portfolio.
Let’s consider a recent real-life example – going back in time to March of 2020, the S&P 500 dropped abruptly by 34% between February 19th and March 23rd. This precipitous drop presented a huge opportunity for tax loss harvesting whereby investors with loss positions could sell at the lowest point of the market while immediately purchasing replacement investments so that they did not lose out on the swift recovery. On paper, many investors were able to realize “taxable losses” while they reinvested their positions to maintain market exposure thereby not losing out on the recovery growth. These “taxable losses” could then be used to offset capital gains (in current and future years) and on a smaller scale to offset taxable income.
Tax Loss Harvesting involves four important steps:
1. Monitoring investments to identify positions with losses
2. Selling positions with losses
3. Immediately replacing the positions sold with a suitable replacement . The replacement position cannot be too similar to the position that was sold to realize the loss. For example, if you were invested in an ETF tracking the S&P 500, you should not replace your loss position with another S&P 500 index fund. The IRS would see this replacement as “substantially identical” and the loss would be disqualified.
4. After a period of 31 days, you would be eligible to sell the replacement security and re-purchase your original position. If you buy back the same position (or substantially identical) before the end of the 31 days, you will trigger the “Wash Sale Rule,” which again would make your loss disqualified.
Why tax loss harvest?
This strategy may help lower tax bills by reducing or deferring capital gains, reducing taxable income, and offsetting future gains and income. It can only be utilized for taxable investments (assets held outside of retirement accounts). Using this strategy to defer taxes today may achieve higher ending wealth through the potential growth of assets not used to pay taxes.
Tax Loss Harvesting is a strategy that we implement when the market provides opportunities – whether the stock market pulls back broadly or there is a correction in a particular asset class, we are ready to act. These opportunities often arise at times where investor sentiment is at its lowest (remember March 23, 2020?) and it may be difficult to see the opportunity through the fog of pessimism that surrounds the situation. But hindsight has shown us time and time again that uncertainty creates opportunity for the disciplined and we have seen the benefits of this strategy realized over time for our clients.
While this is an important tool in our professional toolbelt, it is one that we implement with great caution. The IRS has published much guidance on the issue and there are many nuances (which we have not gone into great detail here) that can make this strategy very tricky for individual investors. We advise that this is a strategy to be considered after consultation with your Sterling Wealth Advisor and tax advisor.
Sources: yCharts. Cruz, Ashley. “Tax Loss Harvesting: A Primer for Investors”, research paper, Dimensional Fund Advisors, October 2024.
