Tax Loss Harvesting
- Brian Zellers, CFP®, AAMS®
- Dec 19, 2024
- 4 min read
KEY TAKEAWAYS
If your portfolio includes an individual or joint investment account (from here on I’ll use the term “brokerage” account), you may be able to control taxes that you might owe from selling your holdings.
Selling positions that have not worked out, in order to realize a loss, is called tax loss harvesting.
Tax loss harvesting can put money back in your pocket or keep you from owing more to the IRS.
MAKING MONEY VS. TAXES
There’s an old saying when it comes to investing and taxes – “Don’t let the
tax tail wag the investment dog!” Huh?? Let me explain.
As discretionary investment managers, our job is to make you money.
When you make money, as most know, the IRS wants its portion in taxes.
Should taxes always rule the roost, or is it sometimes better to just make
money? What if you could make money and control taxes?? If your investments
are held in a brokerage account, as opposed to an IRA or a Roth IRA, this
becomes an important question. Let’s take a look but first let’s see how these
different types of accounts can affect taxes.
THE IRS’ VIEW ON DIFFERENT ACCOUNT TYPES
While there are a multitude of different types of investment accounts, to keep things simple, I’ll focus on just three; Traditional IRAs, Roth IRAs, and Brokerage Accounts. Here are the highlights of each.
Traditional IRA
Tax-deferred growth
Distributions are taxed as INCOME
Penalty for early withdrawals (10% before age 59 ½) – Not a good idea!
Roth IRA
Tax-free growth
Can withdraw contributions tax-free
Distributions are TAX FREE (after age 59 ½ in most cases)- Thank you US Government!
Brokerage account
Taxed only when growth is REALIZED
Growth is taxed as CAPITAL GAINS (short or long-term)
Potential for CAPITAL LOSSES – Keep reading, it’s about to get good!
A BROKERAGE ACCOUNT IS THE KEY
If you don’t own a brokerage account, keep reading, maybe it will be something that will fit your plan! If you own a brokerage account, keep reading, this applies directly to you. If you’re not sure if you own a brokerage account, keep reading and then call your financial advisor.
As active managers in client accounts, we typically have a long-term view. After all, the IRS taxes the sale of appreciated holdings (capital gains) more favorably if they’re held long-term (see below). This doesn’t apply to IRAs or Roths because, remember, the growth is tax-deferred or tax-free. Without going too far down the proverbial “rabbit hole” here is a simple explanation:
Long-term capital gains – Held for 366 days or longer – usually taxed at 15% or less
Short-term capital gains – Held for less than 366 days – taxed at the taxpayer’s income rate
Long story short, (pun absolutely intended) it’s more favorable, from a tax perspective, to sell for a gain in a
brokerage account after a year. CAVEAT – Stocks can sometimes “run-away” and in these cases, it might make sense to take SHORT-TERM gains, and make money, at the cost of paying a little more in taxes. Look at the chart to the left of Cheesecake Factory stock |Ticker : CAKE|. The blue box shows how, in 6 short days, the stock went up almost 22%! From that high point you see what happened afterwards (red downward arrow). The appreciation in its value outweighed the short-term taxes paid in this hypothetical example. The tax tail (paying taxes), therefore, is not wagging the investment dog (making money). Make sense?
HOW CAN TAXES BE CONTROLLED THEN?
To answer this question, let’s forget about capital gains and focus on CAPITAL LOSSES.
Sometimes stocks don’t work out. If you had bought CAKE in the red circle and watched as it went down in value over the next several months, it wouldn’t feel good. However, if you sold it for a loss of say $1,000, that REALIZED short-term loss can be combined with
any other losses from other holdings to offset any realized gains. If you can generate enough losses, the IRS will allow you to take a total of $3,000 in total NET losses each year, and that number lowers your income, which puts money right back in your pocket. If you have more than $3,000 in losses, the leftover carries over to the next year to be used again and this can go on indefinitely.
THE POINT IS…
This is exactly what tax loss harvesting is. No one wants to take a loss. Understandable. The reality is if you own stocks, some don’t work out. So why not sell those that are down, realize a loss, and then use that to lower any tax bill created from any realized gains? That’s what we do near the end of each year in brokerage accounts and that’s called tax loss harvesting. Realize a loss. Lower your taxable income. Save some money. You can even buy the stock back after 31 days if you like it enough. Why 31 days you ask? That’s another lesson for another time!
