Tax Loss Harvesting
By Tom Pappenfus
The recent stock market correction – the first 10% stock sell-off in four years – could provide an opportunity to lower taxes through a practice called tax loss harvesting.
Tax loss harvesting is the strategy of selling investments with reportable losses to offset capital gains in other investments.
For instance, maybe you re-balanced your portfolio earlier in the year, and you realized some capital gains as a result. Or perhaps you received a capital gains distribution from a mutual fund you hold. Now might be a good time to find potential losses to offset those gains and lower your tax liability.
This makes sense only for investments in taxable accounts and not retirement accounts such as IRAs or 401(k)s. And, of course, you should consult with a tax professional.
For tax purposes, note the holding period of your investments. Assets owned for more than one year before you sell them generate a long-term capital gain or long-term capital loss. Long-term gains get a lower preferred tax rate. Short-term gains (from investments held one year or less) are taxed as ordinary income.
Long-term losses offset long-term gains, and short-term losses offset short-term gains. However, once losses neutralize gains within the same holding period, you may apply excess losses to gains of the other length. For instance, net short-term losses could offset net long-term gains.
When all losses exceed all gains, you may apply up to $3,000 a year to help lower your taxable earned income at the federal level. Some state allowances vary. If net losses are more than the allowable amounts, the remainder may be carried forward to future tax years.
Tax considerations should not supersede your investment plan. However, it is important to pay attention to the possible effects that taxes can have on your investment returns. If you think of taxes as a cost you incur as an investor, then minimizing that expense will improve the net return of your portfolio.
In determining whether to harvest investment losses, be sure to:
- Watch how selling investments at a loss could throw off your allocations and leave you with a riskier portfolio. Long-term investors can use tax loss harvesting as an opportunity to re-balance. You can sell losers to try to get your portfolio allocations back in check.
- Figure in transaction costs. Make sure the possible tax savings are worth the cost of the trade.
- Understand that tax loss harvesting goes against the fundamental investing idea we’ve all learned from Day 1: Buy low and sell high.
Minimizing taxes is just one factor investors should consider in trying to maximize investment returns. Tax moves should not take priority over an individual’s overall investment plan. Consult with your investment advisor as well as a qualified tax professional to see whether tax loss harvesting makes sense for your situation.
Tom Pappenfus is a registered representative and investment advisor at Landaas & Company.
- Capital gains are another tax consideration investors should be aware of, to learn more read Capital gains distributions, by Tom Pappenfus.
- Ron Hansen talks about Mutual Fund Distributions in a two-part Money Talk Video
- FAQ About Taxation for Mutual Fund Investors, Investment Company Institute
- IRS Publication 550, Investment Income and Expenses
(initially posted Oct. 30, 2015)