At some point in everyone’s life, there is a somber realization that Uncle Sam is going to get his cut of your hard-earned dollars. The only remedy for this situation is often expressed in the old saying…“It isn’t how much you make, it’s how much you keep”.
Luckily, investing within a brokerage account is one of the situations where a tax break can be created to offset taxes on investment gains. This is done through a strategy called “tax-loss harvesting”. With new tax rules on investment gains likely to come out of Congress in 2022, tax-loss harvesting will become even more important. Of course, Crown employs this strategy in all taxable accounts to ensure our clients keep more of what they earn.
This is an important and effective strategy used to ensure your investment dollars are more useable when the time comes. You would think all advisors do this for their clients, but the truth is, most don’t. It requires time, attention, and an investment in technology – all things Crown makes a priority.
What is it?
At the end of each calendar year the IRS taxes investors on their capital gains (when an investment is sold at a profit). Investors can offset those gains by “harvesting” other investments by selling them at a loss, instead of holding them with hopes of future profits. By offsetting capital gains with capital losses, investors can minimize or eliminate taxes owed from their investment portfolio. This offsetting dynamic is appliable and interchangeable to both short-term (investments held less than a year) and long-term gains/losses.
While some investment managers only implement tax-loss harvesting at the end of the year, Crown has invested in technology that allows us to focus on this strategy throughout the year. Markets are moving up or down on a daily basis which presents opportunity at many points in the year.
How does it work?
Let’s say an investor earns a $20,000 profit by selling Stock A. The investor also sees that Stock B is currently trading at a loss of $12,000. By choosing to sell Stock B the investor is using the losses to partially offset the gains from Stock A. This results in only owing taxes on profits of $8,000 instead of $20,000. If we assume a capital gains tax rate of 20%, the tax bill would only be $1,600 instead of $4,000.
It is important to note that the “harvesting” of the $12,000 loss does not have an effect on the value of the investment portfolio. The cash from the $12,000 sale can be immediately reinvested into another stock. A similar stock can be chosen, such as a competitor of Stock B, to help maintain the same asset allocation as well. The end result is a very similar portfolio but with a more efficient tax position.
Why do we do it?
Besides the main reason of minimizing capital gains taxes on an annual basis, there are some other important benefits of tax-loss harvesting.
When losses exceed gains in a given year, up to $3,000 of those losses can be deducted from ordinary income when filing taxes. If we assume a 35% marginal tax rate, this results in an additional $1,050 in tax savings.
However, the main reason involves the long-term impact of the tax savings that remain in the account. In our above example, there was a $2,400 tax savings that remained in the account. Because of those savings, this investment portfolio will be able to grow and compound at a faster rate than it would if the money was withdrawn to pay for taxes on an annual basis. Ultimately, this results in better performance and a larger portfolio over time. This is especially true for large investment portfolios.
Rule to know
The wash-sale rule is the most important factor when deciding when to harvest a loss. The IRS rule says losses will not be recognized if within 30 days of selling the investment, an investor buys a “substantially identical” security. This means you need to wait 31 days to buy back the same stock/ETF that was sold. The best way to work around this rule is to buy into a similar stock, such as a competitor in the same industry, or a similar ETF.
By implementing a tax-loss harvesting strategy that is consistent and thorough, investors will save money on their taxes and increase long-term investment results. Essentially, this strategy not only ensures that investors keep more of what they make, but also helps maximize what they keep.
Steve Lindgren - Chief Investment Officer