Strategy: Tax-Loss Harvesting

If you were holding onto hope for Biden’s student debt relief package to shave off some of your student debt, looks like you’ll have to wait a little longer. SCOTUS still hasn’t reached a verdict. Though, they’re getting closer.

And while getting some of your student debt reduced would be really nice, at this point I would say, don’t hang all your hopes on it. Instead, start making a plan for repayment now… before you HAVE to start repaying on August 30 (I’ll talk more about that soon).

Waiting until the last minute to make that plan might get you stuck in a more difficult predicament. The same is true for your tax situation.

And since we’re talking about starting your tax savings strategies sooner, let’s also be strategic about capital gains planning.

When you invest there’s always a chance that you’ll incur losses. One of the ways to make the most of those losses is a tax strategy known as tax loss harvesting.

Now, a lot of people like to wait until the end of the year to implement this. But, with this strategy, like the student loan repayment starting up, you’d do better to start thinking about that now rather than waiting until the end of the year.

Let me explain why…

Janet Behm's
"Real World" Personal Strategy Note

A Strong Mid-Year Strategy: Tax-Loss Harvesting

“Whatsoever a man soweth, that shall he also reap.” - Galatians 6:7

Annual loss harvesting is standard to offset capital gains taxes. Basically, you use the losses from your underperforming stocks to reduce the taxes on investment gains and even on gains from elsewhere in your net worth, like from the sale of a house or a business.

Your “harvested” losses can offset the capital gains taxes you earn during the year, and excess losses can offset up to three grand of ordinary income (half that if you file your taxes using the status Married Filing Separately). And you can carry forward additional losses into the future indefinitely.

(For most folks, capital gains taxes are 15%, but this varies a lot with your income – from 0% to 20% or even higher in some circumstances).

But why do people just use loss harvesting only at the end of the year, treating it like more of an event than a process? Because, to their detriment, they’re not paying attention to their investments and taxes.

December madness

Most people scramble to use tax-loss harvesting – a strategy you can put in motion quickly – when the calendar runs out, the dust has settled on stock market gyrations, and their tax situation has become clearer for the year.

This isn’t necessarily in the best interests of your portfolio – or your taxes. Many investors harvesting losses simultaneously at the end of the year can further torpedo the value of underperforming equities. You also might sell a stock you believe will turn around just because you’re harvesting at the last minute of a tax year.

A few general rules

Do use market downturns throughout the year. Wall Street doesn’t always pay attention to the calendar, not to mention that external forces often depress the market – like with the pandemic in 2020 – before a big rally later in the year. Investments ripe for tax-loss harvesting early in the year may not be so at year’s end. Think about harvesting whenever your portfolio takes losses.

Do keep your portfolio strategy front of mind. Harvesting can be a chance to get rid of investments that don’t fit your long-term needs anymore.

Do match your harvesting. Match long-term gains against long-term losses; ditto short-term gains and losses. And selling stock on a short-term basis to offset long-term capital gain property (which again is taxed at a lower rate) is probably not the most efficient tax use of a capital loss.

Do follow up on your tax-loss harvesting of the previous November or December. In the excitement of a new year, it’s easy to forget tax moves from late in the previous one. Early in the year (and at all other times), remember to replace the clunkers you sold to harvest losses.

But…

Don’t violate wash sale rules. These say you can’t replace a security you sold for loss harvesting and replace it 30 days before or after by a security that’s too similar. Break this rule and the IRS won’t allow your loss deduction.

(What’s “similar?” The IRS calls it “substantially identical” and says that ordinarily stocks or securities of one corporation are not considered substantially identical to stocks or securities of another corporation – except in some cases like a reorganization of the same company. Similarly, bonds or preferred stock of a corporation are not ordinarily considered substantially identical to the common stock of the same corporation, except if they’re convertible into common stock of the same corporation. Prices can be another factor – but funds held by different brokerages aren’t usually considered “similar.” As always, check with your tax pro).

Don’t over-harvest. Once you see how this tactic can help your tax bill, you might hanker to sell, sell, sell. But remember that short-term capital gains rates – those on securities you hold for less than a year – are higher than long-term ones. Constantly selling and replacing can also rob you of growth in investments.

Don’t forget to budget for trading costs. These crop up, in one form or another, when you sell securities.

Don’t mistake tax deferral for tax avoidance. You’re deferring taxes with loss harvesting, not avoiding them. Look at your future brackets, too: Do you expect to be in a higher tax bracket in the future? If you are and the market rallies then, you may pay even more tax on realized gains than if you hadn’t harvested.

Don’t let the tax tail wag the investment dog. Loss harvesting can be a great tool to lower your taxes but always think first of your portfolio’s growth potential and purpose. And don’t try to do it on your own – it’s been known to backfire even on investment pros.

Tax-loss harvesting is a powerful tool for slashing your overall tax liability. But it's important to consider the impact of this strategy on your overall investment strategy. Selling losing investments could water down your portfolio's diversification and diminish its growth potential.

The bottom line – Tax-loss harvesting can be a great way to save money on taxes, but do your research and make sure you get someone on your team before you start selling losing investments.

BE THE ROAR not the echo®

Janet Behm