Jennifer Boxberger, CAIA®
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Key Highlights
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Tax-loss harvesting, can be a prudent strategy that can help reduce your overall tax liability by converting investment losses into tax savings. An ideal candidate is an investor who holds taxable accounts and has material realized capital gains or other income sources to offset any realized losses.
Tax-loss harvesting works this way: You sell underperforming securities that are currently worth less than what you paid for them. Those losses can be used to help offset realized gains from other capital assets in a portfolio, such as securities or real estate. In addition, the proceeds from the sale can be reinvested in other investments such as other securities that may better align with your current portfolio strategy. Tax-loss harvesting is applicable only on the sale of securities you hold in taxable investment accounts. Investment assets held in tax-deferred retirement accounts like a 401(k) or an IRA are not eligible.
Comparing long-term and short-term capital gains
When an investment is sold for a profit, you owe capital gains taxes on the profit based on how long the asset was held. The IRS imposes higher taxes on short-term capital gains. For example, selling a stock you owned for less than one year at a profit would trigger a short-term capital gains event and as such are taxed at the ordinary income tax bracket ranging from 10% to 37%.
If the stock is sold at a profit more than one year after the original purchase date, the gains would be taxed at a long-term capital gains rate. Long-term capital gains rates range from 0% to 20% based on your taxable income and filing status. Offsetting long-term capital gains with realized losses has the potential to lower a tax liability, especially for an investor in a higher tax bracket.
Tax-loss harvesting can also be used to offset taxes on ordinary income. After capital gains have been offset, individual taxpayers or married couples filing a joint federal income tax return can write off annually up to $3,000 of ordinary income. Married investors filing separate income tax returns can each deduct $1,500 of ordinary income. If you have more than $3,000 in realized losses, the excess amount of losses can be carried forward to offset capital gains in future tax years.
Additional considerations
As tax-loss harvesting can fund the purchase of new investments, there are rules to consider. After selling an asset, you may want to buy a similar type of investment asset to align with your current investment strategy. However, the IRS has a rule to prevent investors from taking advantage of this benefit known as the wash sale rule.
The wash sale rule prohibits an investor from claiming a deduction from a loss on the sale of an original asset if a “substantially identical” security is purchased 30 days before or after the sale date.1 If this occurs, the loss from the sale of the original asset is disallowed as a deduction. The amount of the disallowed loss is added to the tax basis of the replacement security, deferring the loss on the original asset until the position in the replacement security is sold. In addition, the investor’s holding period on the original asset is added to the holding period of the replacement security.
The IRS doesn’t specifically define what makes assets substantially identical. Generally, stocks from two different companies aren't considered identical, except in certain cases like a reorganization or merger. Also, stocks and bonds from the same company aren't usually considered identical, unless they can be converted into each other.
Tax-loss harvesting can be done at any time of the year. Many investors engage the strategy toward the end of the calendar year as they start thinking about additional tax-related activities. However, Commerce Trust suggests the strategy be started earlier for planning purposes as part of an ongoing investment management regimen.
Tax-loss harvesting can be a valuable tool in reducing your tax liability. Given the complexities to the strategy that require consideration, consult your wealth management investment professional before making any asset sales to ensure changes align with your long-term portfolio goals.
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CAIA® is a registered certification mark owned and administered by the Chartered Alternative Investment Analyst Association.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of November 5, 2024. This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust. This material is not a recommendation of any particular security, is not based on any particular financial situation or need and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.
Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to customers. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
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