Even in a year like 2020, when portfolios took a nosedive in March and US markets reached historic highs by the end of December, you may still have investments that haven’t met your goals and lost money. At the same time, you may have sold other investments to help make ends meet, especially if you lost your job or wanted to help out your family members. When tax season arrives, the tax bill for selling those investments comes due.
But there’s one strategy you can use that might help lessen that bill: tax-loss harvesting. This is where you sell a losing investment, then use that loss to reduce your taxable capital gains. Here’s how it works.
Note: Tax-loss harvesting is only effective in taxable accounts. You can buy and sell holdings in your IRAs or retirement plans without incurring tax consequences.
Tax-loss harvesting basics
There are four keys to tax-loss harvesting:
- You have an investment that has lost money and that you feel is no longer a beneficial part of your portfolio. You shouldn’t sell a stock that has had a temporary downturn if you feel it’s positioned for outsized growth in the future. (For example, when COVID hit the markets, many quality stocks were hammered. Selling at that time would have locked in a loss when holding on might have resulted in gains).
- You also sell (or have sold) stocks that have appreciated in value.
- You use the loss to reduce your capital gains from the sale of the appreciated stock. If your losses exceed your gains, you can also use up to $3,000 to offset ordinary income.
- You may choose to reinvest the money you had in the losing stock into a new stock. One of the caveats for tax-loss harvesting is that the IRS does not allow you to immediately invest in the stock you just sold at a loss (wash sale rules). If you immediately reinvest in the same stock or one that is “substantially identical” to the stock you sold, you will not be able to claim that tax loss.
When to use this approach
To offset an appreciated stock. This probably makes the most intuitive sense in that you’re balancing gains from an appreciated stock with losses from an underwater stock. Note that any sale must be done in the same calendar year. You can’t suddenly receive an end-of-year statement from your broker showing $10,000 in appreciation and sell a losing stock one month before filing your taxes the following April.
To replace a poor performer. This may not be as intuitive. If you have a portfolio of investments and one just seems to be struggling along, you may stick with it for a while then decide to sell. Even if you don’t have an appreciated stock to offset, selling the poor performer can benefit you three ways:
- You replace an underperforming stock with a better option. Many of us have stock lists that we follow. If you decide the time is right to purchase a stock on your list, selling an underperforming stock in your portfolio can help free up the needed money. Just don’t forget the wash sale rules.
- You offset your income; up to $3,000 can be used to offset your ordinary income.
- Your losses don’t expire. While you have to pay taxes (or offset the gain) on appreciated stocks in the tax year that you sell, tax losses don’t have to be used within that one year. For example, if you sell a stock that has lost $15,000 and you have no appreciated stocks, you can use the $3,000 year after year to offset income until it’s used up.
Rebalancing
Rebalancing your portfolio is another area where you can use tax-loss harvesting to your advantage. Let’s say 30% of your portfolio was in tech and 30% in airlines. This past year, tech outperformed while many airline stocks saw their values cut by 50% or more. As a result, your portfolio may be 50% tech and 15% airlines. You may choose to sell some of the tech stocks (to realign your account) and your airline stocks (to both remove a poor performer and to provide tax loss benefits for the tech stock sale). You may then invest in other transportation or travel stocks; or if airline stocks no longer fit within your portfolio, you may want to sell all of them and move into a sector that more closely fits your goals.
Long-term vs short-term gains and losses
As you probably know, stocks held for more than one year (long-term stocks) are taxed differently when sold as compared to short-term stocks (held for a year or less). When you sell a mixture of long- and short-term stocks, any long-term loss would be applied to a long-term gain, and a short-term loss to a short-term gain. If losses exceed gains in one of these categories, they can be applied to either short-term or long-term gains.
Don’t focus solely on taxes
While this strategy can provide tax benefits, investors should never forget their overall investing goals. Review your portfolio and use this strategy when it makes sense for your overall objectives, not just to save a little on taxes. If a company’s metrics still show it’s a value, instead of selling you may want to purchase more while the stock’s on sale.
Photo by Nataliya Vaitkevich