Make no bones about it: 2022 has not been kind to investors. Persistent inflation, rising interest rates and the Russia-Ukraine war have all driven major stock market indexes down throughout the year.
As of Dec. 7, the S&P 500 was down about 17%, while the Dow Jones Industrial Average had dropped more than 7% since the start of the year. The Nasdaq Composite has fared even worse, falling nearly 31% in 2022. Those licking their wounds as they assess the red in their portfolios may be on the hunt for practical ways to staunch the hemorrhaging.
And there’s some good news: These market losses present an opportunity of sorts for investors. No, you don’t have to be an optimist – just a pragmatist willing to handle your portfolio’s downside strategically. How? Those who make a profit from selling investments can lower their tax bills associated with those gains by selling investments on which they’ve lost money. This is known as tax-loss harvesting, and it can be an especially effective strategy for lowering your tax liability and preserving a larger percentage of your investment gains.
Below, we’ll show you the impact that tax-loss harvesting can have on an investor’s bottom line. For help with tax-loss harvesting and other portfolio moves, consider working with a financial advisor and a tax professional.
Scenario 1: Investment Losses Aren’t Harvested
Imagine a scenario in which an investor, Kevin, sells enough stock to produce $60,000 worth of capital gains in a given year. However, not all of Kevin’s investments have been winners. He also has a stock in his portfolio that has gone down in value since he purchased it several years earlier. If he were to sell that stock today, he would take a $30,000 loss. Instead of offloading his losing position, Kevin hangs on to the stock in hopes that it will rebound.
Kevin has a high income and is subject to a 20% long-term capital gains tax rate. As a result, he has a tax liability of $12,000 associated with his $60,000 in capital gains ($60,000 x 20%). After paying taxes on the gains, he’s left with a $18,000 net profit (realized and unrealized) across his two investments.
Scenario 2: Investment Losses Offset Gains
Now consider a scenario in which a hypothetical investor named Kim uses investment losses to offset some of her capital gains. Kim’s investments don’t perform quite as well as Kevin’s, but she’s still able to generate $55,000 in long-term capital gains over the course of the year. And like Kevin, Kim also has $30,000 of investment losses in her portfolio.
However, Kim opts to offload these losing investments. Selling at a loss stings, but doing so lowers her realized capital gains by $30,000. As a result, she only pays taxes on her net capital gain, $25,000. Harvesting her losses lowers her tax bill to just $5,000, meaning she’s left with $20,000 after paying the IRS.
Despite the fact that her investments underperformed compared to Kevin’s, Kim ends up with more money because she harnessed the power of tax-loss harvesting.
Beware the Wash-Sale Rule
An important directive to understand when tax-loss harvesting is the wash-sale rule. This tax rule prevents investors from writing off losses if they (or a spouse) repurchase the security within 30 days of the sale. That applies to the 30 days before and after the investment is sold.
Additionally, this rule will disallow the tax write-off if the investor purchases a substantially identical security or gains access to it through certain investment strategies such as options trading.
So, for example, if you were to sell a Vanguard S&P 500 exchange-traded fund (ETF) and wanted to use that money to purchase another investment, you’d want to replace it with one that takes a different strategy, perhaps tracking another index. Swapping your ETF for an essentially identical fund from another company that follows the S&P 500, for example, could land you on the wrong side of the wash-sale rule.
Don’t Forget to Carry Forward
For investors whose capital losses far outweigh their gains, carry forward may provide tax relief into future years.
For this strategy, taxpayers can carry forward up to $3,000 per year in capital losses to offset ordinary income. This applies to joint, single and head-of-household filers. It’s up to $1,500 for married folks filing separately.
Drawbacks to Tax-Loss Harvesting
Tax-loss harvesting is not always the right call for an investor.
Perhaps the most straightforward drawback is that it locks in losses. If you think a stock is going to rebound, selling it may not make sense.
It also involves making judgment calls about your current tax bracket and where you see future rates going. For example, if you’re in the 0% capital gains tax bracket, it may be wise to recognize capital gains in that year. For 2023, the 0% capital gains income cutoffs are $44,625 for single filers and $89,250 for joint married filers.
Additionally, tax-loss harvesting requires being crystal-clear on your investment basis, tax paperwork and the wash-sale rule. For insights into how to best approach it, consider working with a financial advisor and tax professional.
Bottom Line
As you can see, harvesting investment losses for tax purposes can be a savvy portfolio move. However, it relies on accepting the reality that a previous investment did not pan out, and as a result, cutting your losses. Additionally, there are rules and strategies to understand, including the wash-sale rule and carry-forward. A financial and tax professional may be able to guide through you these strategies.
Tips for Managing Your Portfolio
- Turn to a pro. If you’re unsure how to invest your money, a financial advisor can help. Advisors can select investments on your behalf and occasionally rebalance your holdings to keep your portfolio in life with your financial goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Don’t try to time the market. While it may be tempting to sell assets right before a market dip, predicting the right time to do so is exceedingly difficult. Bob French, a chartered financial analyst (CFA) and director of investment analysis for Retirement Researcher, found that market timing strategies are hypersensitive and can easily underperform compared to buy-and-hold tactics. Mistiming your exit or reentry into the market by even one month can drastically alter an investor’s long-term outcomes.
- Keep track of your investment timeline. Keeping track of how long you’ve owned an asset is vital, especially when it comes time to sell it. Gains realized from selling an asset that you’ve held for less than a year are taxed as ordinary income. However, investment gains derived from an asset that you’ve had for over a year receive a more favorable tax treatment and are taxed as long-term capital gains. Use our capital gains tax calculator to estimate your tax liability.
Don't miss out on news that could impact your finances. Get news and tips to make smarter financial decisions with SmartAsset's semi-weekly email. It's 100% free and you can unsubscribe at any time. Sign up today.
Photo credit: ©iStock.com/tommaso79