Enjoying the read?
Subscribe to read more retirement insights.
To say 2022 has been volatile may be the biggest understatement yet. Many advisors look to tax-loss harvesting as a strategy to take advantage of the rocky equity markets. It can be a valuable silver lining in times where optimism is scarce.
In a nutshell, tax-loss harvesting is the selling of securities at a loss so that you can use these losses to offset current and future capital gains. Here’s how it works: When you sell a stock, bond or mutual fund at a loss, you can use that loss to offset capital gains. If you have an overall net capital loss, you can deduct up to $3,000 against your ordinary income. Short-term capital gains are taxed at your ordinary tax rate, while long-term capital gains are taxed at a 15% (or 20% for higher income-earners). If you’ve owned the security less than one year, the gains will be considered short-term, and anything over that is considered long-term.
Let’s look at an example. Say you’re a single tax filer with $100,000 of wage income, and you own two stocks: Acme has a $10,000 unrealized long-term gain this year, while Boffo has a $10,000 unrealized long-term loss. At this level of income, if you sold Acme, you would owe $1,500 in taxes. With tax-loss harvesting, you could sell Boffo as well and reduce that capital gain tax liability to $0.
If the long-term loss on Boffo were even higher, at $13,000, you could not only offset the entire capital gain from Acme, but use up to $3,000 of the remaining loss to offset ordinary income. Given $100,000 of wage income, this results in a tax savings of approximately $720.
The holding period is critical to keep in mind, because short-term losses must first be used to offset short-term gains, and the same for long-term gains and losses. If you have short-term losses but also have unrealized long-term capital gains on securities you are considering selling, it may be best to hold off so you aren’t using the short-term (and more valuable) loss against income that would be taxed at the lower 15% or 20% rate. Any unused capital losses after applying $3,000 to ordinary income can be carried forward to future years.
Tax-loss harvesting can also reduce your Net Investment Income surtax. This 3.8% surtax is assessed on certain types of unearned investment income (such as dividends, rent and royalties, taxable interest and capital gains) if your modified adjusted gross income exceeds $250,000 for a married couple filing jointly ($200,000 for singles). By harvesting your losses, you can lower your capital gains income and offset your other investment income by up to $3,000 during the tax year.
Caveat: According to the wash sale rule, if you buy a security (or substantially identical security) 30 days prior to or 30 days after you sell the initial security, you can’t use the loss for tax purposes. Instead, the loss is added to your basis in the newly acquired asset. This is to prevent people from selling a depreciated stock to utilize the tax loss while still reaping the benefits of its appreciation.
The wash sale rule can be avoided by buying a comparable, but not identical, asset that you would anticipate having similar performance. By doing this, you can benefit from the realized loss while still allowing your investment portfolio to experience similar growth.
As you can see, the rules can get tricky here, so be careful and get plenty of advice before you move. While Baird does not offer tax or legal advice, the advisors at Baird Retirement Management regularly work with clients’ attorneys and tax professionals to help ensure that all aspects of wealth management are addressed. If you’re strategic about how you sell your declining assets, tax-loss harvesting can be the upside to the stresses of a down market.