Harvesting Losses can be about More than Taxes

Sheaff Brock Investment Advisors tax harvesting investment strategies portfolio gains

Harvesting Losses can be about More than Taxes

Tax loss harvesting is the practice of selling a security that has experienced a loss. By realizing, or “harvesting” that loss, investors are able to offset taxes on both gains and income. The sold security might be replaced by a similar one to maintain the same asset allocation strategy.

How does tax loss harvesting work?

An advantage of taxable accounts is the ability to use the losses that inevitably occur in some years to lower your tax bill. There are three benefits, explains bogleheads.org.

  1. Tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future.
  2. After offsetting gains realized in one year, you can use any remaining losses to deduct $3,000 from regular income tax.
  3. Remaining losses may be “rolled over” into subsequent years until the losses are used up.

But there may be a whole lot more to harvesting losses than tax savings, Sheaff Brock portfolio manager and financial planner Paul Coan reminds investors.

  1. Often clients have large holdings in one particular stock, which works counter to diversification of their portfolio. (The stock may be that of a former employer; sometimes a stock is earmarked by the client as a “legacy” for the next generation.) “Loyalty” and habit may be deterring clients from making needed diversification changes in their portfolios. Or, clients may want to wait until the stock price “comes back” before selling. Remembering that company in its glory days, they find it difficult to accept the reality that there may not be good prospects for that stock going forward.
  2. Investors often think of tax harvesting as a “now” fix (to offset income and capital gains realized that very tax year). Another way to look at a sell-and-replace transaction is this: If the new replacement security is ultimately sold for a gain after being held at least one year, taxes on that transaction will be at long-term capital gains rates. In other words, the tax rate paid on any future gain could be lower than the rate at which you save from harvesting the loss.

Tax planning caution—the wash sale rule:

The wash sale rule states that you may not offset taxes with a loss if you replace the security you sold with a substantially identical security thirty days before or after the sale.

Since, as Coan emphasizes, the most beneficial tax loss harvesting should involve the greater goal of portfolio diversification, replacing the sold security with an exchange-traded fund that tracks a different index accomplishes both tax planning and diversification. (The IRS does not consider ETFs that track different indices to be substantially identical securities.)

What about the old saying, “Don’t let the tax tail wag the investment dog”? Tax loss harvesting is hardly free of all risk, Coan hastens to remind investors. The possibility always exists for a new investment to underperform the old. Any tax-related tactic should be discussed with one’s tax advisor, he cautions.

“Routines have their purpose,” says ineedmotivation.com. “However, sometimes the routine gets too comfortable and leads to a lack of action.” When harvesting tax losses is the impetus an investor needs to achieve greater overall portfolio diversification, that can be a good thing.

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