Harvesting Tax Losses and Gains
When investing in a taxable account, the timing of trades and the securities chosen can significantly impact your after-tax investment returns. Two tactics that can improve returns in taxable accounts are tax-loss harvesting and the lesser-known tax-gain harvesting.
Capital Gains and Losses
When you sell an asset in a taxable account for a different price than you bought it, you incur a capital gain or loss. Capital gains are taxed either at your marginal income tax rate for short-term gains (for assets held for up to 12 months) or at preferable long-term capital gains tax rates that range from 0%-20% (for assets held longer than 12 months). If your capital losses exceed your capital gains for a given year, you can use up to $3,000 of the capital losses as a deduction from your other income (whether or not you itemized deductions), with any additional losses carried over to future years. It is important to note that this discussion only applies to “realized” gains and losses, those that result from a sale of an asset. An asset’s price can appreciate indefinitely without incurring capital gains taxes until it is sold.
While everyone would like their investments to increase in value, tax loss harvesting can dampen the blow of investments that have gone down in value since they were purchased. In general, tax loss harvesting entails selling an investment that is currently worth less than its purchase price and then re-investing the proceeds into a different investment. The sale creates a capital loss that can be used to offset capital gains or as a deduction from income if total realized capital losses for the year exceed capital gains.
Watching out for Wash Sales
A potential pitfall for those interested in tax loss harvesting is what is known as the wash sale rule. Under this rule, an investor is ineligible to claim a loss on an asset if they bought shares of a “substantially identical” asset thirty days before or thirty days after the sale. For example, if you sold shares of Apple stock for a loss, but bought more shares of Apple ten days later, you would not be allowed to take a capital loss on the shares you sold. On the other hand, selling shares of Apple for a loss and then buying shares of Microsoft the next week would not trigger the wash sale rule. If a wash sale does occur, the disallowed capital losses are added to the cost basis of the newly purchased shares.
Tax-gain harvesting is a technique where an investor realizes capital gains in years when their other income is low enough to take advantage of the 0% long-term federal capital gains rate. For 2020, those with taxable income below $80,000 (married filing jointly) or $40,000 (single filers) will pay no federal tax on realized capital gains that year (though the capital gains might be subject to state income tax). For those whose income falls below the annual threshold, tax-gain harvesting can result in significant tax savings. Because of the elimination of most required minimum distributions (RMDs) for 2020, more individuals might be able to take advantage of tax-gain harvesting this year.
Here at The Family Firm, tax efficiency is an important part of our investment approach and both tax-loss and tax-gain harvesting are important tools that our financial advisors and investment team consider for our clients.