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Tax loss harvesting can be valuable, and possibly even significant, for the right investor.
This is the conclusion of a recent Vanguard survey. The company looked at the practice of tax-loss harvesting (TLH) to determine when this practice is most useful for an investor’s portfolio. Specifically, the authors analyzed how this can help maximize the value of a portfolio at minimal costs. The value, they discovered, can vary considerably but can be quite useful depending on the situation.
They found that for the right investors, tax-loss harvesting can increase a portfolio’s value by about 0.5% to about 4% over the long term. The most likely value is an increase in total portfolio profit of about 1%.
As we begin to wrap up 2024, with just a few weeks left to manage your annual capital gains, here’s what you need to know. Consider talking to a financial advisor about your own tax strategy.
Tax loss harvesting is the practice of selling assets in your portfolio for a capital loss to reduce your total taxable income, either capital gains or income. In this practice, an investor will typically reinvest the money from the sale in a broadly similar asset or asset class. The result is an overall tax reduction that allows you to maintain your target asset allocation.
You can offset the capital gains against any amount of capital losses you incurred in the same year. In most cases there is no limit to this practice, which can reduce your taxable profits to zero if you had equivalent losses. You can also offset up to $3,000 of earned income annually against capital losses. To do this, you must have no remaining taxable capital gains during the year (no gains at all, or no remaining gains after offsetting losses).
For example, let’s say you made $75,000 this year. This would net you federal taxes of approximately $8,761. However, suppose you also own shares in ABC Co. has steadily lost its value. You sell these shares for $5,000, making a loss of $2,500 from when you first bought them. This leaves you with a capital loss of $2,500.
You can use this harvested loss to offset some of your taxable income, bringing it down to $72,500. This would reduce your federal taxes to about $8,211, saving you about $550 in taxes. You can then take both the $5,000 proceeds from your stock sale and your $550 in tax savings and reinvest the total $5,550 in a company with a profile similar to ABC Co., but one that may perform better in the long run. This allows you to keep your desired asset classes, exit a depreciating investment, and reduce your taxes, all in the same transaction.
Note – It is important that the reinvestment assets are not specifically comparable. The Wash Sale Rule prohibits the practice of harvesting tax losses and then purchasing assets that behave virtually identically within 30 days. The purpose of this rule is to prevent you from buying back the same asset. This doesn’t prohibit you from generally buying similar asset classes, such as other stocks or bonds, but it may prohibit you from reinvesting in certain funds.
Joe Schmitz, founder of Peak Retirement Planning, Inc., said that tax-loss harvesting “can be a powerful strategy for reducing the amount of capital gains you owe on your investment account. This is especially valuable if you have large gains in your investment account, brokerage account and large losses.”
However, Schmitz noted that a tax-loss harvesting strategy doesn’t work for every investor. “If you’re a buy-and-hold investor,” he noted, “this may not always be the best choice, because you would be selling shares low rather than letting them recover. But if your goal is to make something to sell low to compensate for something. If that is high, it can save significant money in taxes.”
Schmitz’s comments go to the heart of Vanguard’s findings. A tax loss harvesting strategy won’t work for every investor, but it can be very valuable for the right profiles. You can use this free tool to match with a financial advisor if you are interested in personal guidance.
Tax-loss harvesting doesn’t work for every portfolio.
Notably, this is typically not a strong approach for long-term buy-and-hold portfolios, like most retirement accounts. Actually, this approach has no value either untaxed retirement portfolios such as Roth IRAs. Long-term portfolios typically rely on a restored value plan, meaning your goal is to leave assets in place to restore their value after a loss. Actively utilizing tax losses in a long-term portfolio can reduce or even eliminate these potential gains.
Instead, Vanguard identified three specific factors that drive value for a tax-loss harvesting strategy. They are:
This category refers to your portfolio’s ability to generate losses that you can harvest for tax savings. This category generates approximately 31% of the profits from a TLH strategy. Most of the value from this category comes from your portfolio’s exposure to volatility, trading frequency, and the nature of the assets you hold in the portfolio.
This category is defined by investor characteristics. Your portfolio’s ability to generate losses is based on how you structure it and how you trade. For example, if you are a frequent trader, you have more opportunities to spot loss harvesting opportunities. If you hold individual or more granular assets, they tend to be more volatile and therefore more likely to present opportunities for loss.
In total, as Vanguard notes, loss generation is one of three critical elements of a tax loss harvesting strategy. You have to take losses to reap them, and those losses are determined by your investor and portfolio profiles.
This category refers to your ability to save a significant amount of money on your taxes through loss harvesting. It determines approximately 32% of the value of a tax loss harvesting strategy. This category is typically defined by your taxes and tax brackets.
This is your margin of decision for investors because it is determined by how you have chosen to structure your profits and taxes. If you make significant capital gains in a year, you can reap greater losses because capital gains can be fully offset by losses. If you have no capital gains, you can only harvest losses up to $3,000 to offset your income. The higher your current tax rate, the more money you save by absorbing losses.
Just as importantly, the more of your tax savings you reinvest, the more profits you’ll make in the long run.
This category relates to the performance of your portfolio and your reinvestments. It accounts for approximately 37% of the value of a tax-loss harvesting strategy. This is also the category of market factors as it mainly concerns issues over which the investor has no control.
Specifically, the value of your reinvested tax savings is based on the market return on your new investments. If these investments perform well, your capitalization of the TLH strategy will have greater value.
What does this mean for you?
Vanguard found that the value of a tax-loss harvesting strategy depends largely on whether investors are disciplined in reinvesting their tax savings. It also depends a lot on their tax rates. These two factors work together: higher tax rates mean more savings, which means more reinvestment.
In contrast, lower tax rates reduce the value of a tax loss harvesting strategy, possibly all the way to zero. It is important to understand that risk.
For example, suppose you are an individual selling $30,000 worth of stock, with $15,000 in other income that year. This income level puts you in the 0% capital gains range, meaning you wouldn’t see any tax benefits from offsetting these gains. You would have to take capital losses worth $33,000 to fully offset your gains and then the annual maximum of $3,000 in income before you could see a benefit in tax loss harvesting that year (note that capital losses can be carried forward into the future) . year if more than $3,000).
The result is that in the right situation, tax loss harvesting can have real value for your portfolio. Don’t sell valuable assets at a loss just hoping for some tax savings. Make sure this is really an asset you want to sell. Then wait for the right opportunity. This can be valuable – for the right profile. Talk to a financial advisor if you are interested in evaluating your investment and tax strategy.
Tax loss harvesting is the practice of selling assets at a loss to save money on your taxes. As Vanguard explains, if you reinvest these savings in your portfolio, this practice can be a powerful moneymaker.
Now that we’ve talked about the profiles of tax loss harvesting, let’s talk more about what this practice entails. Here’s the weeds, the nitty gritty of how tax loss harvesting works, and how you can apply it to your own portfolio.
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