No one likes a seeing their investments lose value. Young or old, aggressive or conservative, retired or still working – downturns are always unsettling. But, as advisors, we ask what opportunities exist in any situation, including downturns. One such opportunity is called tax loss harvesting. We’re going to cover what it is, how it can help and when you might consider using it.
What is tax loss harvesting?
Let’s say you buy a stock at $100 and it falls to $75. The value of your stock is down, but you haven’t actually lost anything until you sell it. But when you sell, you now have “realized” a $25 loss. If you were to generate $25 in gain through the rest of that year, your loss would cancel out that gain and eliminate the taxes you would otherwise have owed. Less taxes equals more money in your pocket. That’s tax-loss harvesting in a nutshell.
Why not just sell and rebuy immediately? Well, if you want to use that loss to offset other gains, the IRS requires you to stay out of that stock for at least 30 days (otherwise, they consider this a “wash sale” and don’t allow you to take the loss on your taxes). But we also don’t want to leave those funds sitting in cash, missing out on potential return. So, the proceeds can be invested in a similar holding during that time to maintain your market exposure. For example, if you sell an S&P 500 fund to realize a loss, you might pick a growth stock mutual fund to invest those funds for the required 30 days.
How might I use this?
Here are two common scenarios where tax-loss harvesting can help.
- Selling to offset large gains. In the Seattle area, large tech companies like Amazon and Microsoft include company stock in their compensation packages. If you’re one of these employees, you’re likely to end up with a high concentration in that company’s stock and want to diversify that risk. But if that stock has a large gain, you could be looking at a sizeable tax bill when you sell. Looking across your portfolio and realizing losses in other holdings can be a great way to offset the gains in your company stock.
Case Study. A client with roughly $5.0MM in total portfolio assets had accumulated nearly $2.0MM during her tenure at Microsoft. Her cost basis, or the value she paid for it, was only $500,000. She certainly didn’t want 40% of her investments in one company but wasn’t looking forward to the $300,000+ tax bill she would incur on sale. However, we were able to take advantage of the recent market downturn and create a $500,000 loss in her other holdings. This allowed her to realize $500,000 in gain from Microsoft stock with no taxes due. The cash proceeds were then reincorporated into her portfolio across dozens of high-quality stocks and bonds.
The end result? A significant risk reduction by reducing the Microsoft concentration from 40% to 26% of the overall portfolio and a $0 tax bill.
- Selling to create large losses for future years. When the market suffers a steep, short-term correction, we can use the same strategy to build an inventory of losses for use in future years. These losses can be used to offset future gains indefinitely until exhausted. Rather than moving to cash and not being invested, we reinvest the proceeds into a similarly allocated portfolio (remember, we can’t repurchase the security we sold for at least 30 days). Realizing the losses now allows you to offset any realized capital gains and, as a bonus, allows you to offset up to $3,000 per year in income.
Case Study. Clients with $1,000,000 primarily in Vanguard stock funds and a cost basis of $900,000 recently saw their portfolio decline to $700,000 in the recent downturn. While no one likes to see this, we saw an opportunity to realize $200,000 in losses to offset future gains. We sold the existing positions and immediately bought funds with similar underlying stock. The investment allocation remained roughly the same but the $200,000 capital loss could now offset future capital gains and write off up to $3,000 of income per year.
The end result? A similarly allocated portfolio and a $200,000 loss to offset future gains, reducing future capital gain taxes by $30,000 or more.
But how could tax loss harvesting increase my return? Your monthly statements are a quick way to see return in your portfolios, but they only tell part of the story. To get your real return, you’ll want to know what you made after all expenses, including taxes. If you’re able to reduce your tax bill through tax-loss harvesting, you’ll have more money in your pocket…or said another way, an increased return after taxes.
To illustrate, here’s a side-by-side comparison from the Microsoft example discussed earlier, assuming she owned 6,700 shares of MSFT, the current stock price $100/share and the cost basis was $25/share.
|Value Before Tax-Loss Harvest||Value After Tax-Loss Harvest|
|6,700 shares of MSFT||667000||667000|
|20% Capital Gains Tax*||100000||0|
|Net Gain After-Tax*||400000||500000|
This investor added $100,000 in net gain after taxes through tax strategy – money she otherwise would have lost to taxes. That’s a painful check to write to the IRS.
Why don’t we sell all the positions that ever have a loss in my portfolio? First, it’s important to remember that this only applies to taxable investment accounts. Your IRAs, 401(k)s and other retirement accounts are tax deferred and don’t generate capital gains. In your taxable investment accounts, while creating realized losses helps with taxes, tax loss harvesting is a tool best used in big swings and not as an ongoing strategy for every position that goes into the red. As we’ve all seen, enduring day-to-day and quarter-to-quarter volatility is part of being a successful long-term investor and we don’t want to abandon the “stay the course” mentality. However, in the occasional major downturn, it’s a strategy worth discussing with your advising team.
The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.