Tax-Loss Harvesting 

From lemons to lemonade…

Excerpted from The IRA and Retirement Plan Owner’s Guide to Beating the New Death Tax by James Lange

Most investors think the volatility in the market is a bad thing.  Downturns in the market are almost always unpleasant.  But when, not if, the market goes down, consider having a strategy in place to take advantage of the downturn.

Tax-loss harvesting is an important tax planning strategy.  We write about tax-loss harvesting every year in our year-end tax planning letter, but it is best to practice tax-loss harvesting throughout the year, particularly after a market drop.

The following information does not apply to the assets you have in tax-qualified assets like your IRAs or retirement plans but does apply to non-qualified or after-tax accounts most likely in brokerage accounts you may own.

Tax-loss harvesting is the practice of selling a stock or a fund at a lower share price than your purchase price.  To properly execute this strategy, you can’t just select a stock that is down for the year and sell your shares; doing so may cause a taxable capital gain.  Tax-loss harvesting is selling a stock that is currently trading for less than the price you paid for your shares.

Most readers with money outside their IRAs and retirement plans have significant appreciation in those investments.  If some of those highly appreciated investments are now underwater, at a break-even point, or at a price that would only incur a small capital gain, selling them while they are down may be a good strategy.  Of course, this only applies to a taxable account, not an IRA or retirement plan.  University professors tend to accumulate most of their wealth in their retirement plans, but this is still an important strategy to understand.

Adam Yofan of Buckingham Strategic Wealth offers the following simple example:

Tax-loss harvesting can lead to permanent tax decreases or increased tax deferral.  Either way, it will save you money.

There is an important limitation—you can’t sell a stock, deduct the loss, and buy the same stock back the next day.  The government knows that stocks fluctuate in value; they don’t want people selling to get a tax deduction when investments go down to immediately buy back the same investment so that they can benefit when it goes up in price.  When you sell a stock or fund for a tax loss, you have to wait 30 days before you can buy back the same security in a taxable account.  This is known as the wash rule.  However, you can work around this rule, to some extent, by buying a different stock or mutual fund that is similar to the security you sold for a loss.

Current tax laws allow you to use an unlimited amount of capital losses to offset capital gains.  For higher-income taxpayers, lowering current year investment income by loss harvesting will generate even greater savings.  These taxpayers might lower their Net Investment Tax, which is an additional 3.8% tax assessed on net investment income above certain levels.  Again, this applies to investments held outside of qualified retirement plans.

This topic deserves much more attention, but that is beyond the scope of this column.  If you are interested in employing this strategy, you should contact your investment advisor to discuss the topic and the specifics of your situation in detail.

Key Idea

Tax-loss harvesting can lead to permanent tax decreases or increased tax deferral.  Either way, it will save you money.