Lemonade: Who Benefits from Tax Loss Harvesting?

As the saying goes, “When life gives you lemons, make lemonade”. While the market has felt like a sour lemon lately, some are leaning into a concept of tax harvesting to make lemonade.

I recently heard someone saying that the very best thing you can be doing right now is tax loss harvest. His statement has me worried. Is everyone being told that they should go make lemonade?

First of all, it’s probably best that I define the ingredients of the lemonade:

  • Tax loss harvesting only applies to taxable accounts. This concept doesn’t apply to the trades placed in 401(k)s, IRAs, Roth or other retirement vehicles.
  • In a taxable account, when you sell an investment, you are subject to capital gains tax on any amount that the investment increased while you held it. Of note, before you sell an investment, you aren’t paying any taxes on the ups and downs of the market value.
  • If you have had the investment for more than a year, capital gains tax rates are different than the rate you get taxed on your ordinary earned income. For these “long-term” gains, you may be taxed at 0%, 15%, or 20% depending on your taxable income. You can sometimes pay even more, depending on your situation.

It’s helpful to think of tax loss harvesting as a tax deferral method. You get to reduce your taxes now, but later, you are likely to pay taxes on a larger gain. I think this is best illustrated in this graph:

Let’s assume you buy Stock A for $100 and, after a rough market slide, you sell Stock A for $50.  In this example, you get to claim a $50 capital loss which lowers your tax liability on other capital gains.  A little lemonade in the middle of the lemons.

Now let’s assume that you buy a similar Stock B with the proceeds of the sale for $50, and that someday in the future it is worth $150 after a market rebound.  This capital gain of $100 reflects that you sold a stock which was purchased at a much lower price than Stock A.  If you had held onto Stock A, and it had performed similarly to Stock B (an assumption, I know), you would only pay taxes on $50 of gains.  The Schwab article “How to Cut Your Tax Bill with Tax-Loss Harvesting” dives further into the details.

As you may have guessed, because of the sliding scale of the capital gains rates and the potential for larger gains in the future, tax loss harvesting’s impact can be very different for different clients.

Vanguard did a nice (but rather technical) tax harvest study that you can find here. The Vanguard white paper highlights those best situated to benefit from tax loss harvesting as a strategy.  I’ll narrow it down to two initial important factors:

  1. You currently pay at a higher capital gains tax rate than you expect to pay in the future, OR you do not expect to sell during your lifetime
  2. You have capital gains to offset the capital loss within the next few years (remember, capital gains carryover if unused)

If either of these two factors are true, strategies for harvesting long-term losses are more likely to create a positive impact for your wealth. In these cases, tax aware strategies like harvesting and direct indexing may be elevated to a higher priority during portfolio management. Of course, you should consult with your tax advisor before moving forward.

Some find that tax loss harvesting can be very beneficial, but if those two items don’t apply to you, harvesting aggressively may not be to your advantage. It could even cost you more in taxes over your lifetime.

Now is a great time of year to touch base with your tax advisor about the impact of harvesting on your situation. Passing that information onto your investment advisor could help us better serve your long-term goals.

It’s a good time to make lemonade, but only if it’s the right drink for you.

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