What is tax-loss harvesting and how does it work?
By regularly reviewing your investments for holdings that have dropped in value, you can potentially turn a loss into a savings come tax time
When you own investments, on any given day some of them are likely worth more than what you paid, others worth less. Even in a rising market, individual stocks, bonds, mutual funds or exchange-traded funds (ETFs) may lag. And during a period of market volatility, investments that had been growing may suddenly — if temporarily — drop below your initial purchase price.
That doesn't mean you have to sell them, but if you do, there may be an upside. They can potentially create an opportunity to reduce your federal income tax liability. By "harvesting" the losses, much as a farmer might harvest a crop, you may be able to offset taxable capital gains — or even your ordinary income — with your capital losses.
Here's what you need to know about this valuable tax planning strategy, and what questions you can ask your tax professional as you periodically review your investments.
How does tax-loss harvesting work?
Outside of
tax-advantaged retirement accounts, when you sell a stock, bond, mutual fund or ETF for more than you paid for it, you typically owe federal income taxes on your profit, which is called a "capital gain." If you've owned the asset for more than a year, you'll owe federal income tax at a long-term capital gains rate of up to 20% (plus a 3.8% Net Investment Income Tax, if applicable),
depending on your taxable income (PDF). If you owned the investment for a year or less, that profit is considered a short-term capital gain and is taxed as ordinary income.
Let's say you also sell an investment for less than its original purchase price. You may be able to deduct that capital loss from your capital gains, potentially resulting in a lower federal income tax bill. If you have more capital losses than capital gains — or no capital gains at all — you may offset up to $3,000 ($1,500 if married and filing separately) of your ordinary income with capital losses. And you may be able to carry forward any remaining capital losses to offset income in future years.
Making the most of a loss
Here's how much tax-loss harvesting may reduce your federal income taxes, assuming a 15% capital gains rate.
Federal income tax owed on $25,000 long-term capital gain
Federal income tax owed if the long-term capital gain is offset by $18,000 in long-term capital losses
What's the wash-sale rule?
Generally, this is a rule that discourages investors from selling an investment to capture a capital loss and then buying it back right away. You will trigger the wash-sale rule if you purchase the same investment, or what the IRS calls a "substantially identical" investment, at any point within the 61-day window beginning 30 days before the sale and ending 30 days after the sale. If you repurchase the same or a substantially identical security within that window, you won't be able to claim the capital loss on your federal income tax return.
Suppose you buy a stock for $50 and sell it for $30, therefore realizing a capital loss of $20. But if the price keeps falling to $25 a share, and you decide to buy it back a week later, you will no longer be able to claim the $20 capital loss. However, you may be able to add the $20 capital loss to the cost basis, or purchase price, of the repurchased stock. In this case, your new cost basis in the stock would be $45 instead of $25, which could reduce your future federal income tax liability if you later sell those shares and realize a capital gain.
Did you know? When you inherit investments, your tax basis is the fair market value at the date of the previous owner's death. Any historical capital loss on that investment does not carry over to you.
How can I avoid triggering the wash-sale rule?
The safest way to steer clear of the rule is to wait at least 31 days before buying back the investment you sold. But the "substantially identical" part of the rule creates some options. Once you've sold a technology stock, for example, you could buy a similar tech company stock without triggering the wash-sale rule.
There may be even more leeway with mutual funds and ETFs. You may be able to replace a fund you've sold with another one that has the same investment focus, such as another large-cap (or small-cap) stock or one in a particular market sector.
To avoid triggering the wash-sale rule, you may also buy additional shares of an investment you plan to sell for a loss more than 30 days before the sale. Whatever strategy you may choose, keep in mind that repurchasing the investment (or a substantially identical one) at a depressed price today may result in a higher federal income tax liability years from now, because you've lowered your basis for federal income tax purposes. Given the complexity of these decisions, be sure to consult a trusted tax professional — along with an advisor, if you work with one — for guidance.
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4 actions considered wash sales:
Buying in your IRA. Tax-loss harvesting doesn't apply to IRAs or 401(k)s because gains within those accounts are tax-deferred. But if you sell an investment for a loss in a taxable account and buy it within the aforementioned 61-day window in a separate tax-deferred account, that's considered a wash sale.
Scheduled purchases. Setting up monthly transfers into a mutual fund or ETF can be a convenient way to invest. But if you sell the fund at a loss, any capital loss on the automatic investment that occurred in the previous 30 days will be disallowed.
Investing across accounts. If you have multiple taxable investment accounts, be careful not to buy the same investment you just sold for a loss in one account in another account.
Not coordinating with your spouse. The wash-sale rule will be triggered if your spouse buys the same investment within the 61-day window.
When is the best time to take a loss?
While you can sell an investment for a loss at any time during the year, it might work to your benefit to wait until late in the year to take losses, so that you'll have a better idea of the capital gains across your portfolio and your federal income tax liability for the year.
Especially during periods of heightened market volatility, reviewing your portfolio regularly for losses may allow you to take advantage of short-term swings. If you're a Merrill Guided Investing client, learn about our
Tax Efficient Management Overlay Services (PDF), which can analyze your portfolio for potential tax loss harvesting and/or other tax management approaches for eligible investments throughout the year.
Tip If you're selling less than all of your stake in a holding that you purchased bit by bit over time, identifying and selling those shares with the highest cost basis, or purchase price, may yield the largest capital loss.
What are some other reasons to sell a losing investment?
But a loss alone is not necessarily a reason to sell — you may still believe it will benefit your portfolio over the long term. Nor is the potential tax savings you might glean from harvesting that loss, especially if you believe the investment might still have an upside. The decision whether to sell or hold can be complicated and requires you to look at your complete financial picture. Before you decide, be sure to ask yourself which choice is more likely to help you keep making consistent progress toward your long-term goals.
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