Had Harry Markowitz thought about it, he probably would have considered tax loss harvesting a free lunch. Markowitz was a seminal figure in the academic study of investing, and he famously called diversification the only free lunch when it came to investing. What Markowitz meant by that was that by properly diversifying your investments, you could reduce your risk without lowering your return. This runs counter to the almost ironclad rule that return and risk are directly correlated – that is, the only way to lower risk is to accept lower return and vice versa. Because diversification allowed investors to avoid this trade-off, he referred to it as the only free lunch available to investors. However, for many investors, tax loss harvesting offers a similar benefit.
Tax loss harvesting is only applicable to taxable accounts. The accounts may be joint accounts, individual accounts or trust accounts, but the one commonality they all share is that any income or capital gains generated in the accounts are taxable to the owner. Capital gains are generated whenever a security is sold at a price that is higher than the price you paid for the security (which is referred to as the cost basis). This difference between the selling price for the security and the cost basis is taxable. If you’ve held the security for less than a year, the gain is taxable at your ordinary income tax rate. When securities are held for one year or longer, the gain is taxed at 15% for most taxpayers, although the rate can range from 0% to in excess of 20% depending upon your income level.
Tax loss harvesting allows you to offset the gain by selling a security or securities whose cost basis is greater than the current market value. The loss generated by the sale is used to offset any existing gains in taxable accounts. Additionally, the proceeds from the sale are typically invested in a substitute security whose price movements should closely mirror the price movements of the security sold. The reason for reinvesting the proceeds immediately is so that the investor can maintain their target portfolio and not hold excess cash. The reason a substitute security must be used is due to something known as wash sale rules. Per wash sale rules, the IRS requires that any security whose sale generates a loss not be repurchased for at least 31 days, or the IRS will disallow the loss. To avoid wash sale rules when tax loss harvesting, a substitute security is typically sold after the 31-day wash sale period and the original security is repurchased.
Tax loss harvesting is something that sounds more complex that it actually is, so let’s take a look at a concrete example. In this example, Sue has generated $23,000 in capital gains and capital gain distributions1 for the year. She has one holding, Rural Telecom Inc, whose market value is $20,000 below her cost basis. She thinks Holler Telco is a good substitute for Rural, so she sells Rural to realize the $20,000 loss and purchases Holler. As a result, she reduces her taxable gains by $20,000, which equates to a tax savings of $3,000 given her capital gains tax rate of 15%. Once the wash sale period has passed, she plans on selling Holler and repurchasing Rural.
The biggest potential downside in tax loss harvesting is failing to find an adequate substitute security. In the example above, if Rural had increased in value by $3,000 during the wash sale period but Holler had not increased in value at all, the $3,000 in tax savings would have been offset by the foregone gain in Rural. Tax loss harvesting also may not be feasible if there are only small losses to harvest, as the trading costs associated with implementing tax loss harvesting may outweigh any tax benefit.
Given the potential pitfalls outlined in the preceding paragraph, tax loss harvesting doesn’t make sense for every investor. Nevertheless, if you’re nearing the end of the year and have substantial gains, review your portfolio to see if it’s an option. If it is, it can save a considerable amount in taxes and provide an indirect way to boost your return without increasing your investing risk.
- Capital gains distributions are made by mutual funds which are simply passing through capital gains generated when the mutual fund sells holdings. Investors in these mutual funds are taxed on these distributions at their standard capital gains rates, and tax efficient mutual funds attempt to minimize these distributions. ↩