Consider Tax-Loss Harvesting to Improve Your Tax Picture

It’s human nature for investors to focus on potential returns rather than consider taxes. Tax planning isn’t fun. But some prudent tax planning throughout the year, rather than a rush in December to try to lower your taxes, could prove lucrative–and a lot less risky—than trying to improve your investments’ pre-tax performance.

You should strive for a healthy balance between investment and tax considerations. One way to help strike this balance is with tax-loss harvesting.

We generally think of harvesting as something farmers do at certain times of the year. But you can also “harvest” tax losses, and you can do so in any season. In fact, tax-loss harvesting could be a delicious way to add value to your portfolio on an after-tax basis.

Find the Silver Lining in Losses

Tax-loss harvesting is when you sell securities at a loss to offset a short-term capital gains liability. Short-term capital gains are usually subject to higher federal income tax rates (35%) than long-term capital gains (up to 15%). You can apply $3,000 in net losses ($1,500 if married and filing separately) against other income in one year. Excess losses are carried forward to the next year, when they are matched against other short-term gains. This continues indefinitely until you have used up all of your losses.

A simple example of tax-loss harvesting in action is a portfolio that includes a U.S. equity index fund. Let’s say the fund has sustained a substantial loss. You could sell the fund and immediately replace it with a similar fund – something with a comparable risk profile and expected return. You would then harvest the tax loss and use it to reduce taxable gains elsewhere in this portfolio.

Harvesting tax losses can be executed in any portfolio and with all types of securities, but it is especially efficient with index funds.

If you’re in one of the upper tax brackets, the possibility of reducing your short-term capital gains exposure is particularly attractive. Tax-loss harvesting can’t restore your loss, but it might soften the blow. And because the funds involved are similar, there would be no change to your overall investment strategy.

When Opportunity Knocks, Open the Door

Most tax planning occurs as the end of the year looms. December inspires action because it’s the last chance to make tax-related trades for the tax year. However, letting the calendar dictate when to engage in tax-loss harvesting is not wise. If there’s an opportunity in March, July, or October, for example, there’s no reason not to act in those months. That opportunity might easily be gone by December.

Tax-loss harvesting thrives on volatility. An ongoing approach will outperform a simple year-end strategy, because volatility is not bound by the calendar. You should consider tax-loss harvesting an important tool that is best used year-round.

The Big Tax Picture

Studies have repeatedly found that investors tend to hang on to losing investments. No doubt many people are convinced that selling a losing fund only “locks in” their losses. Keep in mind that selling winners and holding losers is not an ideal investment strategy.

It may be that tax-loss harvesting is not the right decision for you. Even if you find the perfect replacement fund, the trade still has to make economic sense. Will you generate a sufficiently high level of after-tax return to offset the costs of implementation? Are the available alternative funds suitable?

An even bigger question is how the IRS will view your actions. Repurchase of substantially the same investment within 30 days of the sale will disqualify the loss for tax purposes. For example, if you were to sell an index fund based on the S&P 500 and replace it with another fund family’s S&P 500 index fund, it would be considered a “wash sale”, and the loss would be disqualified. If you were to purchase an actively managed fund or one based on a different index, the loss will qualify for tax purposes.

Working together, your financial advisor and tax professional can review your entire financial picture, analyze the pros and cons of tax-loss harvesting, and guide you through any wash sale complications. With your long-term financial goals in mind, they can advise you when it’s time to gather in the harvest.