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Tax-loss harvesting

Human nature doesn’t help us become good investors.

Our brains are hard-wired to react emotionally to what happens to our portfolios. We get fearful when the value of the portfolio goes down. We become overly optimistic when the value goes up. And we often anchor our thinking to the original price we may have paid for a stock or a mutual fund.

Sell a position for less than what I paid for it? Why would I want to do that? That’s painful!

Yet there are times when selling an investment for less than what you paid for it makes sense.

A Quick Refresher on Taxes

In a taxable investment account (not a traditional IRA, a Roth IRA, or a tax-qualified retirement plan), if you sell an investment for more than you paid for it, you incur capital gains. Those gains are taxable, and you’ll end up paying taxes on them the following year.

But you can offset those capital gains with capital losses—what happens when you sell an investment for less than what you paid for it.

An Example

Suppose Sarah buys 40 shares of the Not So Hot mutual fund for $25/share, a total of $1,000. A year later, the Not So Hot fund isn’t doing well and is priced at $20/share. Sarah sells her 40 shares, and incurs a capital loss of $200. Sarah did what’s called “tax-loss harvesting.”

There are times when selling an investment for less than what you paid for it makes sense.

Sarah also owns 50 shares of the Really Good mutual fund. That fund made a capital gains distribution to its shareholders this year of $2/share. That’s income the fund made that it has to distribute to its shareholders. For Sarah, that amounts to $100 on which she would have to pay taxes.

But since Sarah decided to cut her losses on the Not So Hot mutual fund, and sold her position at $20/share, she realized a capital loss of $200. Sarah can now offset that $100 capital gain distribution on which she would otherwise have to pay taxes. She can also use the remaining capital loss ($100, in this case) to offset ordinary income (up to $3,000 per year).

When Sarah sold her Not So Hot fund shares, she used the proceeds ($800) to invest in a fund in a similar asset category, the Hopeful for Now mutual fund. She plans to hold on to those shares. Let’s assume that fund does well, and in a few years, Sarah’s position is worth $1,200.

If she decides to sell those shares, Sarah will incur capital gains—the $400 increase in the value of her investment. If she doesn’t have any capital losses, Sarah will have to pay taxes on those gains. But she will have avoided taxes in the years prior (that distribution from the Really Good mutual fund and on part of her ordinary income). And if she never sells the shares of her Hopeful for Now fund and leaves them to her heirs, they’ll avoid paying capital gains taxes altogether on the increase in value from original cost to the value on the date of Sarah’s death.

Every dollar you don’t have to pay in taxes this year is a benefit for you.

Benefits of Tax-Loss Harvesting

Tax-loss harvesting can reduce taxes. Every dollar you don’t have to pay in taxes this year is a benefit for you. In some cases, as we saw with our example, tax-loss harvesting can eliminate taxes altogether. If you never sell the investment you bought with the proceeds from the sale of the loss position, neither you nor your heirs will have to pay capital gains taxes on the increase in value from date of purchase to your date of death.

Limitations of Tax-Loss Harvesting

Full disclosure: under certain circumstances, tax-loss harvesting merely postpones the payment of taxes. That’s not necessarily bad, but we want you to understand the limitations of tax-loss harvesting.

You have an investment that’s below what you paid for it. If you hold the position, and eventually sell it, your capital gain, if any, is calculated based on the purchase price. If you sell it for tax-loss harvesting and then buy it back at a later point, it’s likely the new purchase price will be lower than the original price. Should you subsequently sell the fund, capital gains will be calculated based on the second, lower purchase price.

We would make the case that this limitation on tax-loss harvesting applies only under certain circumstances (namely that you subsequently sell the newly acquired position at a profit) while the benefits of tax-loss harvesting are real and immediate.

Whether tax-loss harvesting is right or wrong for you is a matter for you and your accountant or financial advisor to address. We’ve found it a useful strategy for our clients who wish to reduce their current tax bill. Contact us today if you’d like to discuss how your portfolio might benefit from tax-loss harvesting.


Please read important disclosures here.


Meet the Author

Doug Garrison

Partner

Doug is a Partner based in the Houston office and a member of the firm’s Wealth Management practice. He is responsible for delivering investment and planning services to clients. His specialty is assisting clients who are approaching retirement to evaluate the options they have as they prepare for the next chapter in their lives.

Prior to joining Cerity Partners, Doug was a Senior Wealth Advisor at Investec Wealth Strategies. Previously, Doug was Manager, Global Benefits Design, at ExxonMobil. He was responsible for the design of corporate benefit programs including pension, 401(k) plan, medical, and insurance plans. He helped design and implement a corporate health strategies program (“Partners in Health”) and a financial literacy program (“Financial Fitness Program”).

Doug earned a BA in psychology from Yale University and received his MBA in industrial relations from the Wharton School of the University of Pennsylvania. He is a CERTIFIED FINANCIAL PLANNER™ professional.

Doug is an active volunteer at The Woodlands Methodist Church and Jubilee Prison Ministry. He and his wife are also members of the National Leadership Council of World Vision USA.

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