In some cases, selling an investment for a loss can still be a win.
Investing for the long term is a key component of building wealth, but it’s not as simple as “buy low, sell high.” While your wealth grows, an investment portfolio needs some basic maintenance from time to time. For example, your allocation between stocks and bonds may drift beyond your preferred level of risk and require rebalancing. Maybe you want to sell investments to raise cash for a big purchase or better investment opportunity. Whatever the case may be, when it comes time to sell investments in a taxable investing account, selling some investments for losses can help you minimize your capital gains tax obligation.
When the market gives you lemons, it’s time to make lemonade. It’s a counterintuitive strategy known as tax-loss harvesting, and it can help you be more tax efficient over your investing lifetime. We only need to revisit periods such as the fourth quarter of 2018 or the March and April time frame of 2020 to highlight excellent examples of loss harvesting opportunities.
HOW TAX-LOSS HARVESTING WORKS
In a taxable investment account (not a 401(k) or Roth IRA, for example), the daily fluctuations of stocks will have no impact on your taxes, but that changes once you sell an investment or collect a dividend. When that happens, you are charged either a short-term capital gains tax if you held the investment less than a year or a long-term capital gains tax (the short-term tax is higher, as the system is modeled to encourage long-term investing).
Dividends or profits from an investment sale raise your taxable income for the year. But the opposite is true when you sell investments for a loss. When you sell for a loss, it reduces your taxable income for the year. Minimizing taxes, in addition to growth, is critical to get the most out of your savings long term. Therefore, financial planners and portfolio managers will strategically sell investments at a loss — not out of emotion or frustration, but to minimize capital gains taxes now and potentially in future years as well.
Tax-loss harvesting in practice would involve selling an investment for a loss while simultaneously buying a similar investment to hold in its place for at least 30 days. This allows an investor to obtain the loss to offset future gains, reducing tax liability, while also maintaining market exposure to ensure not missing a run-up in the asset class.
While many people often think about tax-loss harvesting at the end of a tax year — when taxes are on the brain — a good strategy should incorporate it through the year, along with rebalancing. According to a recent analysis, a well-executed tax-loss harvesting strategy can add roughly 0.85 percent to 1.1 percent “tax alpha,” or added portfolio value due to tax savings.
THE VALUE OF TAX-LOSS HARVESTING IN PRACTICE
In 2020, when many were worried about the stock market decline, the team that manages Private Client Services client portfolios within Northwestern Mutual Wealth Management Company used tax-loss harvesting as a way to add value for clients. Beginning on March 6, 2020, the PCS team harvested millions of dollars of losses across virtually every asset class to offset future gains. We sold funds that had lost value and moved clients into similar funds to maintain market exposure. This allowed the clients to participate in the market gains that followed the bottom in March.
As we moved into the second and third quarters, we had more opportunities to harvest tax losses in commodities as well as individual equities that investors shied away from in the short term. The result? Our approach to loss harvesting was an extremely positive experience for our clients. In many cases, clients not only experienced positive returns during the year, but they have also been able to eliminate having to pay taxes as they approach April 15, 2021. In fact, some clients were even able to carry forward additional losses to use toward future gains that may come in 2021 and beyond.
While we used this opportunity to add value for our clients and believe in doing so, it’s important to point out that we don’t believe that you should simply sell a holding and swap to something similar immediately when that holding moves to a loss position. And while there are tools available to automate tax-loss harvesting, systematically selling investments for a loss without consideration of a company’s prospects or your broader portfolio can work to your disadvantage.
OTHER LOSS-HARVESTING CONSIDERATIONS
While loss harvesting is a powerful tool, there are some other items to consider. Yes, capital losses can be used to offset capital gains, but rules are different for offsetting ordinary income. There are also cost and tax code considerations as well.
Limits: For a married couple filing jointly, up to $3,000 per year in realized losses can be used to offset ordinary income on federal income taxes (that’s $1,500 for an individual).
Watch administrative fees: Tax-loss harvesting isn’t effective if the cost of trading exceeds the tax benefit.
Wash sale rule: If you sell an investment for a loss and then buy that same investment back within 30 days, you cannot use the realized loss to offset capital gains.
Carry into the future: Realized losses can also be carried over to offset future gains.
If you’re thinking about rebalancing or revisiting your risk profile, reach out to your financial advisor to chat about your goals and how to strategically rebalance your investments while remaining tax efficient.