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Have you purchased an investment this year that’s now worth less than what you paid?
If so, consider tax-loss harvesting (TLH).
It will increase your holdings in the short-term which, on average, improves long-term earnings.
TLH involves selling an investment at a loss in order to purchase more investments with the proceeds plus tax savings.
For example, if you receive a 1500 USD tax break by selling 50,000 USD of a stock, you can then purchase 51,500 USD of stock.
You’ll subsequently compound interest on top of this larger investment.
TLH is particularly attractive if the investment you sell was purchased within a year.
This is because such a sale—called a short-term loss—provides a larger tax break.
A larger tax break equates to more money you can invest and earn interest on.
TLH is more suitable for people in higher
tax brackets.
They receive larger tax breaks by selling assets at a loss.
However, it’s not applicable to tax-advantaged accounts like an IRA or 401(k).
Example
Let’s walk through an example.
Let’s say you purchased 20,000 USD of your favorite index fund a few months ago, but now it’s only worth 15,000 USD.
If you sell it now, you receive 15,000 USD plus a tax break of 1,400 USD (assuming a 28% short-term tax).
You can now invest 16,400 USD in another index fund.
The extra 1400 USD you now have invested will compound interest and grow just like any other investment.
You’ll have a larger tax bill when you cash out, but on average you’ll be better off after all taxes are accounted for.
Let’s say you pay 15% on long-term gains and hold the above investment until it doubles its present value.
Without TLH you’d end up with 30,000 USD before tax and 28,500 USD after.
With TLH you’d end up with 32,800 USD before tax and 30,340 USD after.
Hence, your final tax bill would be larger with TLH (2,460 USD with TLH vs. 1,500 USD without), but the gains would more than offset that.
Wash sale
There is a catch, of course.
You cannot use TLH to repurchase an asset that’s “substantially the same” as the one you sold.
If you’re a fan of IBM, but want to sell your IBM shares for TLH, you’ll need to buy something else with the proceeds.
This is called the
“wash-sale rule.”
It prevents you from claiming a loss on an asset if you purchase more of a substantially similar asset within 30 days.
Good news for indexers: at last check, the IRS considered most index funds not to be substantially the same.
For example, you could perform TLH by selling an S&P 500 index fund and repurchasing one from another provider.
Before doing this, please check with a tax specialist.
Risks
Tax-loss harvesting does involve some risk.
In particular, the investment you sold at a loss may bounce back and substantially outperform what you purchased as a replacement.
You may also suffer transactional costs associated with the sale and purchase.
Finally, there could be unintended taxes or even changes in tax laws that end up neglecting the benefit.
A tax advisor may be able to help you with some of these issues.
Conclusion
If you own an investment that’s worth less than what you paid, TLH can help you improve your earnings going forward.
It requires you to sell the investment and buy a different investment to avoid a wash-sale.
If you held the investment for less than a year, the benefit is better due to higher taxes on short-term gains.
You should be confident that you really want to swap the current investment for an alternative.
You can estimate the benefits of TLH using our tax-loss harvesting calculator.
You can find more information about tax-loss harvesting in
this report from Vanguard.
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