HOW WELL TAX-LOSS HARVESTING BENEFITS THE INVESTOR DEPENDS UPON A NUMBER OF FACTORS
By James J. Holtzman, CFP®, Legend Financial Advisors, Inc.® and EmergingWealth Investment Management, Inc.®
Tax-loss harvesting (Also known as Income Tax-Loss Harvesting), or strategically taking investment losses to offset income, which is being mentioned in the press almost daily in recent years, is a perfectly legal maneuver that doesn’t eliminate income and/or capital gains taxes as it does delay them. Delaying for sometimes as long as decades is valuable because investors earn a return while Uncle Sam waits to get paid.
Many professional investors believe tax-loss harvesting is the only sure alpha! Tax-loss harvesting enables investors that own investments outside of tax-sheltered accounts such as 401(k)s, 403(b)s, 401(a)s, pension and profit-sharing plans and Individual Retirement Accounts (IRAs), Roth IRAs, etc. to use investments with losses to offset realized gains of taxable investments. Losses can even be used to offset up to $3,000.00 or ordinary income such as salaries. Lower income often means lower taxes.
Better yet, these tax losses never expire. For example, if an investor realizes $20,000.00 of losses this year and offsets only $13,000.00 of gains, the $7,000.00 leftover can go against taxable gains in future years.
For example, an investor who purchased 100 shares of XYZ S&P 500 Exchange-Traded Fund (ETF) on December 15, 2017, at the closing price $120.00 a share could have sold those shares on December 20, 2018 for $108.00, realizing a total loss of $1,200.00.
Taking the loss is only half the battle. Investors can’t buy back the same or a “substantially identical” investment for 30 days—or the IRS deems it a “wash sale”. If the loss is taken and the shares are rebought within 30 days, the loss is disallowed. If the liquidated shares rebound in that timeframe, the investor would not profit from the rebound.
A wash-sale doesn’t apply to “substantially similar” investments. In other words, they would be essentially the same investment, but not exactly the same. This is where ETFs can use essentially the same investments, but be different. Most ETFs track broad indexes on asset classes such as U.S. stocks, emerging market companies or corporate bonds. Finding a similar fund is fairly easy.
For example, it is possible to harvest losses by switching between a capitalization-weighted ETF and an equally-weighted ETF. The ETFs own many of the same stocks and deliver similar returns, but they follow different indexes. By swapping one for the other, investors can lower their income tax bill and still have the ability to profit if markets rebound.
Extended market declines can result in investors briefly holding more cash than normal.
Even when the strategy works, investors have to pay the IRS eventually, unless they die without selling the shares or donate them to charity. Deferring income taxes and potentially offsetting income taxed at a higher rate into a lower income tax bracket is a valuable perk.
Income tax-loss harvesting benefits realized by any investor depends on their portfolio and their particular state and federal income tax rate that applies to them.
Tax-loss harvesting is a sound investment practice, but it’s often a timing thing. How well it works depends upon one’s individual circumstances.
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