In 2018 stock market volatility returned with a vengeance, creating market swings the likes of which we haven’t seen in a long while. We saw the market surge to new highs on top of correction-level declines – not just once, but several times – which can be unnerving even for the most patient of investors, especially those intent on staying invested to allow the market to work through its cycles. While it may not have produced the returns investors have come to expect in recent years, the 2018 stock market generated significant opportunities for tax-loss harvesting, which can be just as effective at enhancing long-term returns.
How Does Tax-Law Harvesting Work?
Tax-loss harvesting can be effective when it is used as a deliberate strategy at opportune times throughout the year. At its simplest, the process entails selling a security at a price less than its cost, which generates a capital loss. While that may not sound appealing on the surface, by taking a loss and harvesting it, you can use it to offset any gains or income generated throughout the year which generates immediate tax savings.
As part of the strategy, when the security is sold, another security with similar characteristics is purchased to take its place in the portfolio. It’s possible to simply repurchase the same security, except you would have to wait 31 days to comply with the IRS wash sale rule. The rule says that if you sell an investment and then buy the same investment or one that is substantially the same, within 30 days before or after the transaction, it is a wash sale that can be disallowed for tax purposes. The risk is that, by the time you can legally repurchase the security, the price increases substantially, making it a less desirable investment.
To avoid the 30-day wash sale constraint, you can immediately purchase an investment that is not substantially identical. For example, if you sold shares of Apple stock and replaced it with shares of Microsoft, that would not be considered “substantially identical.” However, if you don’t feel Microsoft’s long-term outlook is as positive as Apple’s, you may have less confidence in your portfolio. As an alternative, you can temporarily replace your Apple shares with a “proxy” investment, such as a technology ETF, which you can sell after 30 days to then repurchase your Apple shares.
How do Investors Benefit from Tax-Loss Harvesting?
In practice, tax-loss harvesting can generate some substantial tax benefits. The tax code allows for up to $3,000 of capital losses to offset ordinary income each year. If your losses exceed $3,000, they can be carried forward to future years. When done properly, you receive an immediate tax break, while still owning an investment that can generate long-term returns. You may eventually sell the investment and owe long-term capital gains taxes at a lower tax rate. So, in essence, tax-loss harvesting is a tax deferral strategy, but it can substantially enhance the long-term performance of your investment.
Would you be better off writing a $1,000 check to the IRS today, or waiting 20 years to write the check? Considering the power of the time value of money, the difference could be substantial. Assuming a 7% compounded annual return on your investments, your $1,000 would be worth nearly $4,000 in 20 years. And, assuming the same tax rates 20 years from now, you would owe roughly the same amount – $1,000 – which means you earned an extra $3,000 on the money you would have paid in taxes 20 years earlier.
Tax-Loss Harvesting Should be Part of a Sound Investment Plan
The above scenario involves some assumptions that may or may not hold. No one can predict with certainty the future long-term performance of an investment and tax rates can change substantially – higher or lower. Should tax rates decrease significantly, the future benefit could be less. However, there are certain situations where tax-loss harvesting can be highly beneficial. If you are investing for future generations, you can defer capital gains indefinitely and the assets receive a step-up basis at death, effectively eliminating the tax consequence. You can accomplish the same thing by donating the investment to charity.
A sound, long-term investment plan should include a rebalancing strategy that seeks to realign the portfolio to an investor’s target asset allocation. Tax-loss harvesting is a strategy within the rebalancing strategy designed to maximize tax benefits while maintaining the integrity of an asset allocation strategy. Like any strategy, tax-loss harvesting should only be performed in light of your overall financial plan and investment objectives. Because it involves elements of timing, security selection (to sell and buy), and tax implications, it is highly recommended that you work with an investment advisor steeped in portfolio management expertise.