While a stock market downturn like the one we are experiencing now can leave investors anxious, you can help make the most of this challenging situation through a variety of financial planning strategies, such as tax loss harvesting.

By “harvesting” the tax losses within a taxable investment account like your brokerage account, you can increase your tax savings and potential cash flow while delaying capital gains taxes until a more opportune time.

Note that this strategy does not work with retirement accounts such as your 401(k) or IRA since they grow tax deferred and losses cannot be deducted.

What Is Tax Loss Harvesting?

Tax loss harvesting is a strategy in which you sell certain investments in a taxable investment account at a loss to offset capital gains. By doing so, you can reduce your overall tax liability and defer any capital gains tax well into the future.

You determine the amount of your loss based on the cost basis for the investments you sell. For example, say you had purchased 100 shares of an exchange-traded fund (ETF) at an average price of $100 per share. Then, following a stock market downturn, you sold all those shares at $70 apiece before the end of the calendar year. Doing so would leave you with $7,000 in proceeds, meaning you lost $3,000.

Now say you gained $10,000 by selling other investments that had increased in value. Using tax loss harvesting, you could use the $3,000 loss to offset your gains and pay taxes on only $7,000 in capital gains.

You could also offset up to $3,000 in noninvestment income, but if you harvested more than $3,000 in losses, any amount above this number could be used to offset investment gains only.

You can use tax loss harvesting to help both reduce investment risk and maximize tax savings. However, be careful about relying on tax loss harvesting as part of a market-timing strategy. Market timing can leave you selling when you should be holding and thus missing out on future gains as the market recovers. However, harvesting your tax losses can be an important tool for a long-term, diversified investment strategy.

The Wash Sale Rule

After your sell your investments at a loss, you can then invest in new securities. However, you should be mindful of the wash sale rule, which bars you from selling losing investments and then purchasing “substantially identical” securities within 30 days.

Although the specifics of the rule can be unclear, it may cause you to shift your investment choices. For example, if you sell an ETF that tracks the S&P 500, the Securities & Exchange Commission could find your purchase of an S&P-tracking ETF from a different company too similar. Instead, you may need to make a more substantial shift, such as selling a large-cap fund and purchasing a small-cap fund.

Alternatively, you could just wait until the 30 days have cleared to repurchase your investments or buy securities that would be considered substantially similar.

Also keep in mind that you can maximize the value of tax loss harvesting by offsetting short-term capital gains, which are those held for a year or less and taxed at ordinary income rates. If you have sold investments that count as short-term gains, determine if you have short-term losses to harvest. Consider reinvesting the proceeds of the sale into investments that you can hold long term and, therefore, pay a lower capital gains tax rate once sold.

Risks of Tax Loss Harvesting

While tax loss harvesting can help you maximize your net returns and reduce your taxes, you should be mindful of the risks. For one, if you sell securities at a low point for the tax savings, then you could miss out on those securities rebounding from a down market, especially if you reinvest in securities that do not recover as strongly.

Tax loss harvesting can also kick the can down the road as to when you pay taxes on investment gains, which could mean that you ultimately pay more if tax rates increase.

The process for tax loss harvesting can be straightforward, but the rules and the risks might leave you wondering if it is the right strategy for you. Talking with a fiduciary financial advisor who understands your entire financial picture and your long-term objectives can be helpful. They will help you identify the securities that are good candidates for harvesting tax losses. They can also help you decide what to reinvest in while remaining mindful of the wash sale rule and tax risks.

This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.

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