Over the last few weeks, the CJM team has been busy rebalancing our client portfolio’s and tax loss harvesting.
So what exactly is tax-loss harvesting? It’s basically realizing a capital loss while maintaining the same exposure. For instance, if in your portfolio, there is a US equity fund with a $50k loss, you can sell the fund to realize the loss and buy a substantially similar US equity fund to take its place. This way you maintain the same exposure but book an accounting loss of $50k. This maneuver is called tax-loss harvesting.
What’s the value of tax-loss harvesting? The accounting loss you book can be used to reduce future income or capital gains tax. Rather counterintuitively, investment losses are thus an asset to be harvested. Let’s use an example to illustrate the point.
- Example: Let’s say you realized the $50k loss from selling the US equity fund. If you should realize a gain of $60k in the next year, instead of paying the 20% capital gains tax on all $60k, that is $12k, you can use your loss to offset the gain. You will end up paying only (60k-50k)*20% = $2k, resulting in a tax saving of 20%*$50k = $10k.
What if you don’t have any capital gains to offset? You can use the loss to offset your income, but only up to $3,000 per year. The unused portion of the loss can be deferred indefinitely into the future. So, the $50k loss can be used to offset $3,000 worth of income for the next sixteen years. For folks in the highest tax bracket, whose marginal tax rate – combined federal, state, and local – is approaching 50%, the tax-saving each year would be $1500, or $24k over sixteen years.
To sum up, with $50k of loss harvested, you will either save $10k in capital gains tax or $24k in income tax. This is also an advantage to owning mutual funds vs individual stocks. Most investors prefer not to sell an individual stock at a loss knowing they cannot buy back the same stock for 90 days in order to recognize the loss for taxes. With mutual funds you can sell a US Equity fund at a loss and buyback, the same day, any other US Equity fund.
Don’t let a loss sit in your investment account- it’s a wasted opportunity to save on taxes.