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October 30, 2023
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By
Jenna Ross
Graphics & Design
- Athul Alexander
- Alejandra Dander
The following content is sponsored by New York Life Investments
Paying Less Tax: The Tax-Loss Harvesting Advantage
No one likes losing money on investments, but it turns out it can have a silver lining. Through tax-loss harvesting, you can use losses to reduce your taxes.
This graphic from New York Life Investments explains how it works, and why investors can consider a proactive approach throughout the year.
What is Tax-loss Harvesting?
Tax-loss harvesting occurs when an investor sells investments in a loss position to offset the gains generated by other investments.
Consider an investor who purchased an ETF tracking the S&P 500 Index for $100,000. It is now worth $87,000 and has lost $13,000 since the investor purchased it earlier in the year. The investor decides to sell the ETF to lock in the losses, and replaces it with a similar—but not substantially identical—ETF.*
Now, the investor can apply the $13,000 capital loss against gains in the following order:
- Capital gains of the same type e.g. short-term losses against short-term gains
- Capital gains of the other type e.g. short-term losses against long-term gains
- Up to $3,000 of ordinary income
- Carried forward to offset gains in future years
*Note that the cost basis of the newly-purchased ETF is now $87,000 rather than the original $100,000 investment. The investor will pay capital gains taxes based on the lower cost basis when they sell, effectively delaying taxes rather than eliminating them.
Locking in Losses
Here’s an example of how the $13,000 capital loss could be used, making the following assumptions about the investor:
- They have a $10,000 short-term capital gain
- They have $3,000 of ordinary income
- They are taxed at 40.8%, which is the top regular income tax rate of 37% plus the 3.8% net investment income tax
Part of the $13,000 loss offsets the $10,000 short-term capital gain. The remaining $3,000 loss is applied against ordinary income, reducing taxes further.
| Gain/Income | Offsetting Loss | Tax Savings |
|---|---|---|
| $10,000 short-term capital gain | $10,000 of the short-term capital loss | $4,080 taxes could be offset |
| $3,000 ordinary income | $3,000 of the short-term capital loss | $1,224 taxes could be offset |
| $13,000 total gain/income | $13,000 total offsetting loss | $5,304 total tax savings |
The $5,304 in total tax savings are reinvested back into the market. Assuming a 6% rate of return, this would add nearly $2,000 to the investor’s earnings in the first five years.
In this hypothetical example, the initial tax savings and reinvested earnings could amount to $7,098. This can potentially continue to compound if the investor keeps the funds in the market.
Maximizing the Tax-Loss Harvesting Opportunity
As you consider tax-loss harvesting, there are a few things you can keep in mind.
| Do | Don’t |
|---|---|
| Use a taxable account | Buy the same or a substantially identical security within 30 days* |
| Harvest losses when you have gains to offset | Harvest losses if you expect your tax rate to go up substantially |
| Have a strategy for harvesting losses, such as when rebalancing a portfolio | React to every downturn in the market |
*The IRS Wash Sale Rule states that if you purchase the same or a substantially identical security within 30 days of the original sale, your tax write-off from the sale is disallowed.
The benefits of tax-loss harvesting tend to be greater under certain conditions, such as when there are larger market declines, when an investor has a high current tax rate, and when the subsequent returns on reinvested savings are higher.
Taking a Proactive Approach
Public interest in tax-loss harvesting, as measured by Google Trends, typically peaks during market volatility or at the end of the year. However, waiting until the end of the year can be problematic for two reasons:
- The deadline for tax-loss harvesting is December 31 of each year
- There is typically a “Santa Claus Rally” where stocks gain value in December
Instead, investors can periodically look for tax-loss harvesting opportunities throughout the year, especially around periods of high volatility. While the market has historically had gains most calendar years, there have been losses within any year.
| Year | Calendar Year Return | Intra-Year Drawdown |
|---|---|---|
| 2000 | -10% | -17% |
| 2001 | -13% | -30% |
| 2002 | -23% | -34% |
| 2003 | 26% | -14% |
| 2004 | 9% | -8% |
| 2005 | 3% | -7% |
| 2006 | 14% | -8% |
| 2007 | 4% | -10% |
| 2008 | -38% | -49% |
| 2009 | 23% | -28% |
| 2010 | 13% | -16% |
| 2011 | 0% | -19% |
| 2012 | 13% | -10% |
| 2013 | 30% | -6% |
| 2014 | 11% | -7% |
| 2015 | -1% | -12% |
| 2016 | 10% | -11% |
| 2017 | 19% | -3% |
| 2018 | -6% | -20% |
| 2019 | 29% | -7% |
| 2020 | 16% | -34% |
| 2021 | 27% | -5% |
| 2022 | -19% | -25% |
Source: Macrotrends, Yahoo Finance, author calculations. Price returns are shown. Intra-year drawdowns are calculated as the largest market drop in a year from a peak to a trough.
Investors who plan ahead can take advantage of these intra-year losses.
A Tool for Investors
By strategically harvesting investment losses, you can offset gains and lower your current tax bill. Not only that, you can reinvest the tax savings to grow your investment return potential.
Explore more insights from New York Life Investments.
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Related Topics: #capital loss #capital gain #tax loss harvesting #New York Life #New York Life Investments #tax
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