4 Things to Consider Before You Tax Loss Harvest

| November 30, 2016

As the year ends, financial conversations start focusing a bit more on tax strategies than other financial planning and portfolio topics, sometimes to the detriment of long term objectives. Tax Loss Harvesting is the classic year-end topic. Like clockwork, right after Black Friday and Cyber Monday mania and just before endless loops of It’s a Wonderful Life, Tax Loss Harvesting will dominate the financial news. That’s because it’s a simple strategy and it could reduce your tax bill.

But before you start selling investments to generate reportable losses, keep the following in mind.

Will it be counterproductive to portfolio rebalancing?  

Tax loss selling doesn’t fit very well with portfolio rebalancing, which is the process of realigning the weighting of different investments back to an original target mix. As one investment or asset class performs well, and another performs poorly or less well, rebalancing shifts the overall mix back to its intended target.

Since the rebalancing process is largely predicated on reducing (selling) your recent winners to increase (buying) your recent losers, tax loss selling makes rebalancing a portfolio difficult, if not impossible. Why? Because tax-loss harvesting involves selling your losers, not your winners. These strategies are not very complementary of one another at best, and clash at worst. Following your rebalancing plan is likely to have more long-term positive benefits than the short-term benefits of tax loss harvesting.

Which taxes are you actually offsetting?

Losses are not applied directly to your taxable income. Instead, losses first offset investment gains, some of which could have favorable tax treatment already. Profits from positions that were held for longer than one year are considered long term capital gains and are capped at a tax rate of 20 percent. So, any harvested losses will be used to eliminate favorable gains before they start to reduce any earned income. Schedule D on your Federal 1040 tax form guides you through the pecking order.

How about selling and re-buying it back?

The IRS is way ahead of you on that one. Wash-Sale rules exist and stipulate if the same or “substantially identical” investment is bought within thirty days before or after the sale, it is not allowed to be claimed as a loss on your Schedule D. Effectively it’s treated as if you didn’t sell. Your cost basis just gets adjusted. Have fun tracking that!

Also, selling and re-buying a position resets its qualified dividend holding period. Qualified dividends are dividends from stocks you’ve owned for 60 days or longer, and they are taxed at the lower long-term capital gains rate. Non-qualified dividends, or Ordinary dividends, are taxed at your marginal rate.

Will you get the full benefit?

If after offsetting all of your gains you still have losses left, the IRS caps your loss at $3,000. Any more will carry forward to the next tax year. That means risking an ineffectively balanced portfolio, eliminating your long-term capital gains, and resetting your qualified dividend holding period will only result in a $3,000 reduction of your earned income.

When should you consider harvesting losses?

Selling an investment should be a constructive portfolio action, not a tax savings reactive one. And of course, anytime you sell an investment, tax implications are an important factor to consider.

  • If you need to raise cash in your portfolio, likely for withdrawals, being tax sensitive is smart.
  • If an investment no longer fits it in your portfolio, selling makes sense.

But if the sole purpose for selling an investment is to increase reportable losses, it can be a short-term fix with long-term consequences. Don’t let the tax tail wave the investment dog.