Tax loss harvesting is a powerful and valuable investment technique that can provide significant tax savings for investors and make the best of a market downturn.
During economic slowdowns and recessions when losses are more prevalent, we typically see most individual investors hold onto their losses because they are afraid to “sell down,” waiting and hoping their investments will rebound over time. However, sophisticated investment professionals are looking at losses every day to determine if they can be harvested for tax purposes while remaining fully invested, providing tangible benefits overlooked by those choosing to invest on their own.
If you are in invested in baskets of funds such as mutual funds or ETFs, any losses you experience on your investments can be harvested to then offset future capital gains taxes in the same year and beyond. To “harvest” the loss, you must first recognize the loss by selling your initial investment. From there, you can simultaneously reinvest in an extremely similar but not identical fund, in order to maintain nearly identical long-term returns for your portfolio. If you experience any capital gains that year or in the future, the loss you experienced will offset the capital gains you accumulate, resulting in zero or reduced capital gains taxes at tax time. When it comes time to file your taxes, the custodian of your funds will provide you the necessary tax forms that detail your annual gains and losses for you or your accountant to include in the appropriate forms on your federal and state tax returns.
Here is a basic example of how the complexity of tax loss harvesting works:
- You bought $100,000 of an S&P 500 Index mutual fund, then markets decline 25% and this investment is now worth $75,000.
- On the same day, you then sell the $75,000 of the S&P 500 index mutual fund and buy back $75,000 of the Russell 1000 Index mutual fund, in order to recognize the $25,000 loss you incurred while also maintaining a similar investment and future long-term returns.
- Since this index has returns that are similar but not identical, it meets the IRS rules, but at 99%+ is a near perfect substitute for the same performance of the S&P 500 Index moving forward.
- If you have capital gains during the year, the $25,000 loss you recognized will offset up to $25,000 of these gains, effectively reducing your tax bill and increasing your returns and the money you keep.
- If you don’t have any gains in the current year, you can use $3,000 of these losses to deduct ordinary income on your tax return for the current year, and then carry forward the remaining $22,000 to future tax years, to offset future capital gains, or $3,000 of ordinary income each year until the harvested losses are used up during your lifetime.
After 31 days, the IRS even allows you to swap back to the S&P 500 Index mutual fund if you want or you can simply remain in the Russell 1000 Index mutual fund beyond 31 days. If markets continue to move lower, you can continue to swap back and forth every 31 days and harvest more losses since there is no annual or lifetime limit to the losses you can harvest.
Unfortunately, tax harvesting is not nearly as effective with individual stocks because one of the key components of harvesting is reinvesting your money in a new investment with very similar performance, so you aren’t sacrificing long-term returns. However, with individual stocks there is little chance the performance of two individual stocks will be nearly identical even if it’s for similar products or companies. This is one of the key reasons we choose to implement baskets of stocks versus using individual stock holdings.
If you are not incorporating tax loss harvesting into your investment strategy, you are not maximizing wealth for you and your family, rather you are doing so for the IRS. At RTD, we are reviewing our clients’ accounts daily to see if there are any losses that should be harvested and react in real-time to capitalize on these situations. Through tax harvesting, we directly reduce a client’s tax bill, sometimes for many years into the future, without changing the portfolio’s overall returns for the long-term.
During the financial crisis in 2008-2009, RTD harvested enough losses for clients with sizeable taxable accounts to essentially make their portfolios tax-free for the next 3-5 years. All the while as markets declined, RTD also rebalanced client portfolios from bonds to stocks on the way down, adding to stocks at discounted prices so on average their portfolios also made new highs well before the broader markets.
Whether this current market downturn proves to be just an economic slowdown, a shallow recession or something more severe than that, this investment strategy technique potentially offers tremendous long-term value for our clients enduring the short-term emotional pain of markets being down sharply for some period of time.
If you could benefit from financial advice like this to make decisions for you, your family, and various type of trusts, we can set up a complimentary virtual phone call or meeting to discuss further. You can do this by emailing us directly at email@example.com, or visit us on our website at https://www.rtdfinancial.com to learn more.