Tax-loss harvesting is a popular strategy, but it’s not always clear whether it’s the right strategy for you until we can look at the whole picture. It’s important to receive professional help from financial professionals in your corner such as your accountant and financial advisor.
We will cover some key issues to consider when you are thinking of implementing a tax-loss harvesting strategy, such as:
- The effect harvesting losses may have on your overall portfolio goals.
- Some common pitfalls and rules to be aware of when harvesting losses.
- The potential tax benefits and consequences that may arise.
- How long-term goals may be affected by tax-loss harvesting.
Do you need to review your portfolio’s asset allocation and your risk tolerance prior to doing any tax-loss harvesting? If so, consider coordinating tax-loss harvesting with any needed rebalancing to your portfolio’s target asset allocation. Harvesting losses may enable you to optimally rebalance your portfolio at a reduced tax cost by offsetting gains from reducing concentrated or overweighted positions.
Do you currently have realized gains or losses (or existing losses being carried forward from previous years)? Make sure to think about whether this impacts your tax-loss harvesting strategy.
In the near future, are you planning to sell an asset (e.g., a home or business) that will be subject to capital gains? If so, consider coordinating your sale with any opportunities you may have to harvest losses. If selling a home, be mindful of any capital gain exclusions (e.g., meeting the 2-of-5-years rule) and whether it applies to your situation.
Are you in the 0% capital gains tax bracket? If this applies to you, consider realizing capital gains (to the extent that your income remains within the 0% bracket) rather than harvesting losses.
Do you anticipate your tax rate to change in the future? Make sure to examine how tax-loss harvesting effectively defers capital gains tax by decreasing your cost basis today. If your tax rate increases in the future, harvesting losses could cause you to pay more for those deferred taxes than if you paid them today. Additionally, extra income from selling the security in the future could push you into a higher tax bracket.
Do you need to review how you plan to reinvest your tax savings? If so, consider the amount of tax dollars you saved from harvesting losses, and review ways you could “reinvest” those tax savings for future growth.
- Example: Make an additional contribution or decrease distributions in your portfolio equivalent or similar to the amount of tax dollars saved.
Do you need to review any state-specific rules that may affect your tax-loss harvesting strategy? Consider the following:
- Many states have limits on (or disallow entirely) the ability to carry forward harvested losses into future tax years. Furthermore, capital gains are often taxed as ordinary income at the state level and may not be subject to the same beneficial tax treatment that other sources of income might within certain states (e.g., Social Security not taxable, retirement withdrawals not taxable up to a certain threshold, etc.).
- Be mindful of whether you live in a separate property or community property state and understand the subsequent tax nuances of harvesting losses and/or gifting securities that may apply to your situation (e.g., 50% step-up in basis versus 100% step-up in basis at death, step-down in basis issues, etc.).
Do you ultimately plan to donate your security to charity? If you do, think about harvesting any available losses now, as decreasing your basis will have no effect on your taxation if you donate your security to charity in the future.
If harvesting losses creates a carryover loss on your tax return, are you concerned that you will have more losses than you are able to use during your lifetime? If so, consider any capital losses that are not used up by the year of death may be permanently lost.
Do you need to plan for avoiding wash sales of securities sold for a loss? Think about the following:
- Purchasing a “substantially identical” security to the one from which you harvested losses (in the previous 30 days or subsequent 30 days of the sale date) in any of your and your spouse’s accounts (including retirement accounts) will trigger a wash sale and prevent you from claiming a deduction on the tax loss.
- Consider turning off automatic dividend reinvestments prior to harvesting losses, as reinvested dividends into a security you harvested a loss from may inadvertently trigger a wash sale.
- Other automated investment features (e.g., automated purchases, contributions, or rebalancing) in any accounts may also cause an accidental purchase of a substantially identical security and trigger a wash sale.
Do you need to review any administrative or trading costs that would be incurred by any tax-loss harvesting? If so, examine how those impacts would mitigate the benefits of tax-loss harvesting.
Tax-loss harvesting can be a savvy way to reduce your capital gains taxes, but it needs to be coordinated with your overall planning. It’s important to not let your tax bill drive your whole strategy.
These are only some of the things to think about when talking to your financial professionals about whether tax-loss harvesting is a good option for you. If you’d like the full checklist, download HERE, and take it to your CPA or advisor to go over.