How to Turn Your Investment Losers Into Winners With Tax Loss Harvesting
Wouldn’t it be nice if every investment you made just kept going up every year? Unfortunately, that’s not the reality. In fact, timing plays a significant role in how your investments perform. Take the S&P 500, for example. Since 1970, the S&P 500 has declined in 13 out of the 55 years, resulting in negative returns. That means about 25% of the time, your portfolio could be down in value.
This isn’t a doomsday scenario, but it highlights a key point: no investment, even in the top 500 companies, are immune from down years. So, it’s crucial to keep an eye on your portfolio each year, especially when it comes to unrealized gains and losses. By doing so, you may uncover opportunities to reduce your current and future tax bills.
How Can You Use Investment Losses to Your Advantage?
Here’s the good news: you can potentially use your investment losses to lower your taxable income and save on taxes. When you experience a loss in a taxable account, you can "harvest" that loss to offset any gains, or even reduce your ordinary income up to $3,000 per year.
Let’s be clear, tax-loss harvesting only applies to investments in non-retirement accounts, such as brokerage or mutual fund accounts. This does not apply to tax-deferred accounts like IRAs, 401(k)s, or Roth IRAs.
Index Funds vs. Actively Managed Funds
I’m a strong believer in index-based investing, particularly through Exchange Traded Funds (ETFs). These tend to be far more tax-efficient than actively managed mutual funds. Why?
With index-based ETFs, you generally won’t receive capital gain distributions unless you sell the ETF yourself. This allows you more control over when you incur taxes.
Actively managed funds, on the other hand, often distribute capital gains to investors, even if you haven’t sold your shares. These distributions can be taxable, and you could end up paying capital gains tax even in years where the fund lost value.
If you’re holding an actively managed mutual fund that’s underperforming, it might be worth considering selling it at a loss and reinvesting in a more tax-efficient ETF. This could help you reduce both your taxes and the cost of your investment management.
How Tax Loss Harvesting Works
Let’s say you have a short-term capital gain of $20,000 this year, and your tax rate is 30%, meaning you owe $6,000 in taxes on that gain. However, you also have another investment in your portfolio that’s lost $25,000. If you sell that investment, you can use the $25,000 loss to offset your $20,000 gain, leaving you with a net loss of $5,000.
Here’s where it gets even better: You can then use up to $3,000 of that loss to offset your ordinary income for the year, which could further reduce your tax bill. The remaining $2,000 loss can be carried over into future years to offset future gains.
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A Second Example
Say you have a long-term capital loss of $15,000, but no other gains this year. You can deduct $3,000 from your ordinary income for this year, and the remaining $12,000 can be carried forward to offset future gains or continue to reduce your taxable income in subsequent years.
Key Things to Keep in Mind with Tax Loss Harvesting
Before diving into tax-loss harvesting, here are a few key factors to consider:
Non-retirement Accounts Only: Tax loss harvesting can only be done with investments outside of retirement accounts (such as your 401(k) or IRA).
Offsetting Gains: Losses first offset gains in the same category. Short-term losses offset short-term gains, and long-term losses offset long-term gains. If there are leftover losses in one category, they can be used to offset the other.
The Wash Sale Rule: This is crucial. You can’t sell an investment at a loss and then buy the same or a "substantially identical" investment within 30 days before or after the sale. If you do, the loss will be disallowed for that year. For example, if you sell an ETF that tracks the S&P 500, you can’t immediately buy another S&P 500 ETF, even if it’s from a different fund family. However, you could sell the S&P 500 ETF and buy a small-cap index ETF or another completely different fund that still aligns with your investment strategy.
Wash Sale Rule Applies Across All Accounts: The wash sale rule isn’t limited to just one account. If you sell a stock at a loss in your Charles Schwab account, you can’t repurchase it within 30 days in your Fidelity account either. The IRS applies this rule across all taxable accounts.
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Consolidate and Rebalance Your Portfolio
Tax-loss harvesting isn’t just about tax efficiency—it’s also a great time to streamline your investments. If you’ve got multiple mutual funds in your portfolio that are underperforming, consider consolidating them into a few high-quality ETFs. This can save you on management fees (which might be eating into your returns) and increase the overall tax efficiency of your portfolio.
To determine what your mutual funds are costing you, visit Morningstar.com. It’s a free tool that will tell you the expense ratios of your funds. You might be shocked to see how much you’re paying in fees.
Final Thoughts
Tax-loss harvesting is a powerful strategy that can help you optimize your portfolio, reduce your tax liability, and even improve your investment’s long-term performance. If you haven’t taken the time to review your taxable investment accounts this year, now’s the time.
If you have a question or topic that you’d like to have considered for a future episode/blog post, you can request it by going to www.retirewithryan.com and clicking on ask a question.
As always, have a great day, a better week, and I look forward to talking with you on the next blog post, podcast, YouTube video, or wherever we have the pleasure of connecting!
Written by Ryan Morrissey
Founder & CEO of Morrissey Wealth Management
Host of the Retire with Ryan Podcast