Tax-Loss Harvesting

Toward the end of the year, financial advisors often advocate tax-loss harvesting. The notion: You sell losing investments—usually stocks and stock funds—in your taxable account, and then use the realized capital losses to offset realized capital gains and up to $3,000 in ordinary income, thus trimming your tax bill.

Sound like a smart strategy? If you trade individual stocks actively—or you’re a really bad investor—you should be on the lookout for tax losses, and not just at the end of the year. Instead, seize the opportunity whenever you have significant losses.

What about those who sit quietly with a handful of mutual funds and exchange-traded index funds, and perhaps also own a few long-term individual stock holdings? Most of the time, there won’t be any losses to harvest.

Yes, if you’re a long-term investor, you might get the chance to realize losses in the first few years that you own a fund or an individual stock. But soon enough, your investments will likely be above your cost basis, and the chance to benefit from tax losses is probably gone forever. Instead, you’ll face an entirely different problem: How do you rebalance your holdings without getting whacked with big capital-gains tax bills? The upshot: If you’re a sensible investor, don’t spend too much time worrying about tax losses. Instead, focus your efforts on your portfolio’s overall tax efficiency.

Still, if you do have a losing investment in your taxable account to sell, the math can be impressive—especially if you don’t have any realized capital gains. Let’s say you have a $3,000 loss on your international stock fund. You realize the loss. Because you don’t have any realized capital gains, you can offset the loss against your ordinary income. If you’re in the 25% tax bracket, that would mean $750 in tax savings.

To maintain your foreign stock exposure, you can’t immediately repurchase the fund you just sold, or you’ll run afoul of the so-called wash-sale rule. Instead, you purchase another international stock fund. That fund then rebounds, so you make back your $3,000 loss. If you held the fund for more than a year and then sold, your gain would be taxed at the 15% long-term capital gains rate, assuming you’re still in the 25% income-tax bracket. Result: You’d pay $450 in taxes, or $300 less than your earlier tax savings.

Better still, you’d hold onto the fund, so the tax bill is delayed, allowing you to use the money earmarked for Uncle Sam to earn additional gains. Even better, you might bequeath the fund to your kids—at which point the capital-gains tax bill would disappear.

Next: Wash-Sale Rule

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