Losses are sometimes part of investing
Some investments lose money. That’s why everyone should have a diversified portfolio. By definition, diversification means your investments are spread out across multiple stocks, bonds, real estate, or other investments. In a perfect world, everything would increase in value, but that rarely plays out in real life. Since it is likely that some parts of your portfolio will be “down” (lower in value) during the year, why not leverage that to your advantage?
When an investment is sold for less than you paid for it, you experience a loss. Perhaps it was a bad investment. Perhaps it was just short term external factors. Maybe you even still like the investment and believe it will gain value moving forward (more on this below). If you haven’t sold the investment yet, it is just “down”, you haven’t actually lost anything until you sell at a lower price point. It’s the same situation with an investment gain – it isn’t a taxable gain until you sell. Once you do sell though and make a loss official, it creates a tax-impacting situation.
What is Tax Loss Harvesting (TLH)?
Investment losses that you experience in any year can be used to offset investment gains in that same year. So if you sell two different stocks, one at a loss for $1,000 and one for a gain of $1,000, you can use the two to offset each other so that no taxes are due on that gain. If you have more losses than gains, you can “carry forward” the losses to offset gains in a future year. You don’t lose this benefit just because you didn’t sell anything for a gain in the same year.
Furthermore, in many cases, you can even use a loss to offset normal income. In 2017 you can use investment losses to offset $3,000 of personal income. So you can save money on taxes even if you don’t have any investment gains in that same year.
Tax loss harvesting is purposely selling some investments that are down to help lower your tax bill for that year. If you were to experience a $1,000 loss that offset your income, that saves you over $250 if your effective tax rate were 25%. That’s nothing to sneeze at – and the benefit could potentially be a lot higher!
Note that you can’t sell a stock or fund and then buy the exact same stock or fund again within 30 days if you want to use tax loss harvesting. That’s called a “wash sale”, which the IRS frowns on and will disqualify your loss. But, there are still some options if you have an unrealized loss, want to save on taxes, but still want to have money in that type of investment.
TLH is still valuable if you like the investment
If you invest in funds – mutual funds, ETFs, etc – as we do, then you have a ton of flexibility with your tax loss harvesting. Tax loss harvesting is still a good option if you like your fund – and can be even more of an advantage! Let’s say you have a growth fund produced by iShares that is down 10%. You can sell that fund and claim that dollar amount as a loss on your taxes. Then you can either wait 30 days to avoid the wash sale rule or buy a similar fund. If you sold the iShares growth fund you can look to replace it with perhaps a Vanguard growth fund. Per the IRS the new investment cannot be “substantially similar”. But it can be highly correlated. So you can replace one fund with another that holds different investments but tracks the same part of the market.
When is tax loss harvesting NOT a great idea?
As with most things, there are some exceptions to TLH being a benefit. If you are in a really low tax bracket right now, that minimizes some of the gains for you. The higher your tax bracket, the more you benefit. Also, if your current tax bracket is so low that you can avoid capital gains taxes, this might not make sense for you. In that situation, you will be very limited in the ability to offset gains – since they don’t cost you anyway.