Beyond Investments- Tax Loss Harvesting

Tax-loss harvesting is one of those peculiar sayings in finance that on the surface doesn’t make much sense and sounds much more complicated than it is. The process is straightforward and can help offset capital gains, potentially saving investors money on their tax bill each year. For many investors who are actively rebalancing portfolios, they will have incurred realized gains throughout the year. Rather than doing nothing and paying the capital gains it’s possible to sell other investments that performed poorly to offset the profits from those that had done well. This strategy, over the long-term, can add value through the following benefits:

* Tax deferral: Losses harvested can be used to offset unavoidable gains in the portfolio, or capital gains elsewhere (e.g., from selling real estate), deferring the tax owed. If these savings are then invested, it has the potential for additional growth over time.

* Pushing capital gains into a lower tax rate: If you’ve realized short-term capital gains (STCG) this year, the gains are generally taxed at your marginal rate (your highest tax rate, paid on your next dollar earned). However, if you’ve harvested losses to offset them, the corresponding gain you owe in the future could be a long-term capital gain (LTCG).

* Converting ordinary income into long-term capital gains: A variation on the above: by intentionally realizing losses we can offset up to $3,000 of ordinary income with capital losses.

* Permanent tax avoidance: Tax-loss harvesting provides benefits now in exchange for increasing built-in gains, subject to tax later. However, under certain circumstances (charitable donation, a bequest to heirs), these gains can avoid taxation entirely.

When conducting tax-loss harvesting, there is a significant rule that needs to be followed called the Wash Sale Rule. Otherwise, an investor will nullify any of the losses they are trying to capture. A wash sale occurs when an investor sells or trades a security at a loss and, within 30 days before or after this sale, buy a “substantially identical” stock or security. The rule was created to keep investors from selling a stock at a loss, then repurchase it one minute later to get a tax benefit without sacrificing anything. When tax-loss harvesting for clients, we buy similar but not identical securities so that the portfolio composition is consistent but avoid running afoul of the Wash Sale Rule.

Tax-loss harvesting is an easy way for investors to benefit from tax savings. Suppose those savings are reinvested over the long-term. In that case, it is easy to see why tax loss harvesting is such an excellent tool for advisors that operate as fiduciaries to utilize for their clients to add more value to the relationship.

Nathan Smith is a Portfolio Manager with Rather & Kittrell.