For some reason, financial advisors will frequently tout tax-loss harvesting as an incredible opportunity, skipping over the fact that it is ultimately a consolation prize for having lost value on an investment. There is absolutely a case for tax-loss harvesting and the potential tax benefits that come from it. But like any tax-planning strategy, tax-loss harvesting requires nuance and communication with clients.
Here’s what advisors get wrong about tax-loss harvesting:
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The Basics of Tax-Loss Harvesting
Tax-loss harvesting is intentionally selling an investment at a loss to lower taxable income in a specific year. Typically, the funds are used to purchase other similar investments to keep the portfolio balanced.
Due to the IRS’s wash-sale rules, however, the same or even a substantially identical investment or security cannot be purchased within 30 days of the sale. If that happens, the loss is disallowed.
Forgetting That Not All Income (or Loss) Is Created Equal
One reason: There are limitations on how losses can be used to offset taxable income. Capital losses, which are losses from the sale of appreciated assets, are first used to offset capital gains. They can offset any amount of capital gains.
Once a taxpayer runs out of capital gains, capital losses can only be used to offset $3,000 of non-capital gains income. Examples include example, wages, rental and business income.
Any additional capital losses are carried forward to future years to either offset future capital gains or be used at $3,000 at a time. There are certainly tax savings to be had here but in a limited way.
Missing That Most Tax-Loss Harvesting Is a Delaying Tactic
Advisors seem to be familiar with, and communicate to their clients, the limitations on the amount of losses that can be recognized in a particular year.
But what often gets missed in that communication is the fact that tax-loss harvesting is not permanent. It’s a delaying tactic at best.
A Quick Example
To illustrate this, assume a client purchases a single share of Fund A for $10,000. Two years later, the share is valued at $5,000. The client’s advisor recommends selling the fund at a loss to offset capital gains. Next, the $5,000 is used to buy a single share of Fund B.
Assume that this does not violate the wash-sale rule and that the taxpayer offset $5,000 in capital gains that would have otherwise been taxed at 20%. Total savings are $1,000 in that year.
Fast-forward two years. Now, Fund A and Fund B are both valued at $15,000.
When the taxpayer sells her share of Fund B, she recognizes a $10,000 dollar gain that is taxed at 20% creating a tax liability of $2,000.
Instead, if the taxpayer had simply kept her share of Fund A, she would have only recognized a gain of $5,000. That’s because she would have kept the original basis of $10,000.
That would have created a tax liability of $1,000 instead of $2,000.
The net impact is the same, but only if tax rates are the exact same in both years. That means you are assuming the taxpayer will not have higher income in the future and that Congress will not increase tax rates in the future.
No one can predict the future. But before recommending tax-loss harvesting, you should ask your clients whether they are concerned tax rates might go up.
This resetting of the basis in their investments is a key piece that must be communicated to taxpayers when performing tax-loss harvesting.
Overlooking How Tax-Loss Harvesting Emphasizes Losses
Another downside to tax-loss harvesting is that it highlights the exact outcome clients are hoping to avoid – investment losses.
In contrast, capital-gains harvesting, or strategically selling investments at a gain, emphasizes the wins in your clients’ portfolios. It has the potential to create more permanent tax savings.
Changing the timing of recognizing income, however, always creates the potential for a negative outcome depending on what tax rates do in the future. If you help a client intentionally recognize a gain now, and tax rates go down in the future or the investment loses value in the future, you have the potential to create a similar situation to what was described above for tax-loss harvesting.
Advantages of Capital-Gains Harvesting
The first advantage to capital-gains harvesting is that there are no wash-sale rules on selling investments at a gain. This means that Fund A can be sold for a gain, then immediately repurchased. This resets the basis of the investment higher and reduces future taxable gains if the investment continues to increase in value.
The second advantage is that, with proper planning and for the right client situations, capital gains can potentially be harvested at a 0% tax rate.
In 2023, for a married couple filing jointly, up to $116,950 (capital gains bracket goes up to $89,250 and the standard deduction is $27,700) of long-term capital gains can be recognized at 0% tax.
This assumes no other income, which at times happens between retirement and starting Social Security. But even if there is other income, the capital gains included in up $116,950 of income are taxed at 0%. That has the potential for incredible tax savings for clients.
Assuming Tax-Loss Harvesting Is a Differentiator
For advisors who are using tax-loss harvesting in their marketing to set themselves apart, here’s bad news: Robo-advisors are doing tax-loss harvesting as well. To be sure, tax-loss harvesting can add value and should be considered at times. But it is not the all-powerful tool separating one advisor from another.
Taxes should be just one of the factors considered for financial planning recommendations. They should almost never be the primary consideration.
Whether considering tax-loss harvesting, capital-gains harvesting or any other tax-reduction strategy, great advisors consider clients’ overall situations and goals before diving into the taxes.
Lead with the client’s bigger goals, then make sure the tax impact is determined. Clients should pay every dollar they owe. But pay attention to this important reminder: Don’t tip the IRS.
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Steven Jarvis, CPA, is a columnist for SmartAsset and has been compensated for this article. Taxpayer resources from the author can be found at retirementtaxpodcast.com. Financial Advisor resources from the author are available at retirementtaxservices.com.