What You Should Know about Investment Tax-Loss Harvesting

Dec 09, 2022

Last week, I shared five money-saving tax moves to consider before year-end.

One of those moves was “tax-loss harvesting,” which involves selling losing investments. As I explained: 

[Selling a losing investment] creates a “realized capital loss” in tax-speak, which can then offset an equal amount of realized capital gains (profits) in other assets that year.

Capital losses can also offset up to $3,000 in ordinary income each year. And any unused losses can be rolled forward to future years indefinitely.

I also shared the following simple example to show you how it works in practice: 

Suppose you sold your position in stock ABC earlier this year for a $10,000 profit, and you will owe $3,000 (30%) in taxes on that gain at your current tax rate.

However, suppose you also own stock XYZ, which is currently showing a loss of $15,000.

If you sell your position in XYZ, that $15,000 loss will completely offset the $10,000 gain in ABC and eliminate that entire $3,000 from your tax bill. You could then apply the remaining $5,000 loss to offset up to $3,000 in ordinary income, reducing your tax bill by another $900 (30% of $3,000).

With this one move, you’ve deferred nearly $4,000 in taxes this year and can “carry over” the remaining $2,000 to offset additional gains or income in future years.

However, I also warned you there are several potential pitfalls you need to be aware of before taking advantage of this strategy for yourself. And this week, I’m going to share some of the most common with you.

Pitfall No. 1: The “Wash Sale” Rule

The most important consideration when harvesting tax losses is to avoid triggering the “wash sale” rule.

This rule states that a capital loss will be disallowed for tax purposes if an investor buys the same or a “substantially identical” security within 30 days before or after the sale.

In other words, you can’t sell a stock to realize a loss and then immediately buy it back. You also can’t buy new shares of a particular stock less than 30 days before selling your original position to realize a loss. If you do, those losses can’t be used to offset gains or ordinary income that year or in the future.

“Substantially identical” means you generally can’t swap one type of security with a similar one from the same company (such as a company’s class A and class B shares). You also generally can’t swap a company’s stock for options, warrants, or other contracts on its shares.

Finally, the wash sale rule applies across all of your accounts (and your spouse’s, if filing jointly), including tax-deferred retirement accounts. That means losses are also disallowed if you sell a stock in a taxable account and immediately repurchase it in a 401(k) or individual retirement account (IRA).

These limitations mean tax-loss harvesting is best suited for losing investments you no longer wish to own or would be willing to buy back more than 30 days later. However, you can also consider selling assets with similar (but not “substantially identical”) alternatives.

For example, if you owned the SPDR S&P 500 ETF Trust (SPY) at a loss, you could sell it and immediately buy the Vanguard S&P 500 ETF (VOO).

Both of these exchange-traded funds track the S&P 500 Index (SPX). However, because they’re managed by different companies, have different expense ratios, etc., they’re not currently considered “substantially identical” investments under the tax code.

You can generally do the same with any number of asset, sector, industry, or thematic ETFs where multiple choices exist.

This approach is more difficult to follow with individual stocks. However, depending on the circumstances, you might choose to temporarily replace a stock with a close competitor or industry ETF to realize a significant loss.

Pitfall No. 2: Calculating Your Cost Basis Incorrectly

To calculate capital gains or losses for an investment, you need to know its cost basis. That is simply the price you paid to purchase it, plus any commissions or fees.

Calculating your cost basis is straightforward if you purchased the entire position at once. However, if you acquired it over time – either through multiple purchases or dividend reinvestments – your cost basis can be expressed one of two ways: by taking the average per-share cost of all the assets (average cost method) or by tracking the actual price of each individual purchase (actual cost method).

The actual cost method can be a hassle if your broker doesn’t provide these figures automatically. However, it can be worth the extra effort when tax-loss harvesting. This method allows you to designate higher-cost shares to sell first, which can often help maximize your realized losses.

Pitfall No. 3: Not Accounting for Short-term vs. Long-term Gains

The government incentivizes long-term investing by taxing short-term gains at a higher rate than long-term gains.

Short-term gains (those realized in assets held for one year or less) are taxed at your ordinary income tax rate, while long-term gains (those realized in assets held for over a year) are taxed at a significantly lower “capital gains” rate.

These tax brackets don’t line up precisely, but ordinary income tax rates range from 10% to 37%, while capital gains rates range from 0% to 20%.

Why is this important? Because the tax code requires that short- and long-term losses must first offset gains of the same type. Only if your losses of one type exceed your gains of the same type can those losses be used to offset the other.

As a result, short-term losses tend to provide the biggest “bang for your buck” when harvesting losses because they are first used to offset short-term gains, which are taxed at a significantly higher rate.

Pitfall No. 4: Ignoring Your Income Tax Bracket

While tax-loss harvesting tends to provide more significant benefits to those in higher tax brackets, investors of all incomes can use it.

However, investors in the lowest brackets should consider this strategy carefully. As I mentioned, these folks aren’t required to pay taxes on long-term capital gains.

Specifically, those who earn taxable income of less than $41,676 ($83,351 if filing jointly) pay 0% on long-term capital gains in 2022. So their losses can only offset short-term gains and up to $3,000 in ordinary income per year.

As a result, this strategy may not be worthwhile for those who don’t have (or plan to have) significant short-term gains. In fact, these folks may benefit more from selling long-term winners instead.

Because they don’t have to pay capital gains, these investors can generally sell a profitable long-term investment without tax consequences and immediately repurchase it. This strategy will adjust their cost basis to the current, higher price, lowering their future tax obligations should their income put them in a higher tax bracket later.

Pitfall No. 5: Unexpected Gains in Mutual Funds

If you own mutual funds, you could realize gains even if you don’t sell shares in a particular year. That’s because mutual funds are legally required to pay out profits from the sale of any stocks each year to shareholders in the form of a capital gains distribution.

These gains can be both short-term and long-term capital gains. Long-term gains distributions can be offset with losses from sales of that fund or other assets. However, short-term gains distributions – unlike traditional short-term gains from the sale of securities – generally cannot be offset with capital losses.

You can find a list of 2022 distributions for most mutual funds here.

Pitfall No. 6: Harvesting Losses in Retirement Accounts

Finally, tax-loss harvesting isn’t viable in retirement accounts like 401(k)s or IRAs. That’s because you generally can’t deduct losses realized in a tax-deferred account.

The Bottom Line

Tax-loss harvesting can be a great way to lower your tax bill, especially in years like this one when you could be holding on to some investments that have fallen significantly below your cost basis.

Keeping these common pitfalls in mind can help ensure you get the most out of this strategy. However, depending on your financial situation, there could be other considerations, so I’d encourage you to run your plan by your accountant or financial adviser before taking action.

As always, you can reach me with questions and comments at [email protected]. I can’t respond to every email, but I read them all.

Stories You May Have Missed

In this week’s TradeSmith Daily, we covered a variety of topics you may find interesting. I hope you’ll take a moment to review them.