Selling an investment to create a tax-loss is generally a year-end strategy for reducing your tax burden. However, you don’t need to wait until the end of the year. But, you do need to understand the rules. If not, you could void the tax benefit you’re seeking!
Tax-Loss Harvesting Defined
An investment that you paid more for than it is worth today is a candidate for tax-loss harvesting. Often considered a year-end activity, tax-loss harvesting can be done throughout the year in non-qualified accounts, such as brokerage accounts. It refers to the strategy of selling an investment that is down, realizing the loss, and then using that loss to offset any current or future capital gains in your portfolio. This process, if done correctly, can reduce the amount of taxes you owe.
It’s a good strategy to implement in a year when investments, such as mutual funds, are likely to pay out significant capital gains. It can even be useful in years where you have no realized capital gains, because such losses can be used to reduce current ordinary taxable income up to $3,000 each year. Any excess losses can be carried forward indefinitely to offset future gains or income.
Understanding the Implications of Tax-Loss Harvesting
Change in Portfolio Allocation: Selling underperforming investments can help to reduce the taxes you owe and can remove the negative impact those investments can have on your portfolio. However, selling investments will alter the overall allocations among the different types of investments in your portfolio, realigning your investment mix. Inadvertently, you may now be taking on excessive risk.
“Wash Sale” Rule: The IRS defines a “wash sale” as a violation that occurs when you sell an investment at a loss and purchase the same, or a “substantially identical”, investment 30 days before or after the sale. This means that you cannot sell an investment to realize a loss and then immediately buy a nearly identical investment to keep your portfolio essentially the same. Violate this rule and you won’t be able to write off the realized capital loss or use it to offset any gains in your portfolio.
Avoiding a Wash Sale Rule Violation
When investing the proceeds of the sale you must be careful that your new investment isn’t “substantially identical” to your original investment. For example, buying and selling the same security is not allowed.
For investors with actively managed mutual funds or individual stocks, finding an acceptable alternative is fairly simple. Active mutual funds tend to have different investment strategies, while individual stocks (even competitors within the same industry) face risks that are company-specific. For example, The Coca-Cola Company and PepsiCo are both producers of soft drinks, but the two companies have other product lines and face unique challenges. Therefore, immediately selling Coca-Cola stock and buying PepsiCo stock (or vice versa) would not be considered a violation of the wash sale rule.
However, investors who build their portfolio using passive index funds need to be more careful. Due to their similar strategy and construction, it’s likely the IRS would consider passive funds that track the same index to be “substantially identical,” even if they are offered by different firms. For example, an investor that sells a Vanguard S&P 500 Index fund and buys an S&P 500 Index fund from Fidelity is at risk of committing a wash sale. Note: The IRS has never officially ruled on this situation, but you don’t want to be the test case!
Finally, wash sale rules apply to all your investment accounts, not just the account in which the sale was made. To the surprise of many investors, the wash sale rule still applies even if a “substantially identical” investment has been purchased in a qualified account, such as an IRA or 401(k).
Minimizing your tax obligation through effective tax-loss harvesting strategies can help your investment portfolio grow. However, you need to be keenly aware of the change in your portfolio’s asset allocation due to the sale as well as the wash sale rules as the sale proceeds are reinvested. You want to be careful you don’t wash all the savings away!
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