What Is Tax Loss Harvesting?

Tax loss harvesting can be used primarily in taxable investment accounts, such as individual brokerage accounts. These accounts are subject to capital gains taxes when you sell investments at a profit, making them suitable for implementing tax loss harvesting strategies. Tax loss harvesting is generally not applicable to tax-advantaged retirement accounts, such as Traditional and Roth IRAs and 401(k)s.

Tax loss harvesting is typically applied within a diversified portfolio, where individual holding may have different performance characteristics. In tax loss harvesting, investors review their portfolio to identify investments that have declined in value since they were purchased. Once the investments with losses are identified, investors sell these positions to realize the capital losses. This sale generates a loss in the portfolio. Capital losses from the sale of these investments can be used to offset any capital gains realized in the same tax year. By doing this, the investor reduces the amount of taxable capital gains, which in turn lowers their overall tax liability.

If the capital losses exceed the capital gains in a given tax year, the excess losses can be used to offset future capital gains in subsequent years. This can potentially lead to tax savings in the future.

Additionally, if you do not have a capital gain to offset your capital loss, you can use the loss to offset your ordinary income by up to $3,000 per year.

Tax loss harvesting involves several steps to effectively utilize capital losses to offset capital gains and reduce tax liability. Here are the key steps involved in the process.

1. Review your portfolio. Begin by thoroughly reviewing your investment portfolio to identify positions that have declined in value since you purchased them. These are the investments you may consider selling to realize capital losses.
2. Determine taxable accounts. Determine which of your accounts are candidates for realizing capital losses. Retirement accounts, such as IRAs and 401(k)s. do not usually have immediate tax consequences for buying and selling investments within the account and therefore do not contribute to capital losses.
3. Calculate capital gains and losses. Determine the amount of capital gains and losses in your taxable accounts for the current tax year. Subtract total capital losses from total capital gains to see if you have net capital gains or losses for the year.
4. Identify specific lots. If you hold multiple lots of the same security (shares purchased at different times and prices), identify the specific lots with losses that you want to sell. Selecting specific lots allows you to control which losses to realize.
5. Find a similar investment. If you want to realize a loss in an investment account but want to maintain your market exposure in that sector, consider purchasing an investment similar to the one you're selling. This allows you to realize the capital loss without reducing your market exposure.
6. Sell investments with losses and purchase similar investments. Execute the sale of the investments you've identified with losses. Then, use the proceeds from the sale to purchase similar investment securities.
7. Hold the new investment for at least 30 days. When selling an investment security, a provision called the wash-sale rule prohibits you from repurchasing the same or substantially identical securities within 30 days before or after selling them at a loss. Violating this rule would disallow the capital loss for tax purposes.
8. After 30 days, consider repurchasing your initial investment. If you like your original investment more than your new investment, at this point you can repurchase your original security and sell the new one. This ensures that you avoid a wash sale.

The primary benefit of tax loss harvesting is the potential for tax savings. By offsetting capital gains with capital losses, you can reduce or eliminate the taxes you owe on those gains, which can lead to significant savings over time. Additionally, by minimizing taxes, you can potentially enhance your after-tax returns, allowing your investments to grow more efficiently. And since excess capital returns can be carried forward to offset future capital gains, you can experience tax benefits in subsequent years as well.

Tax loss harvesting also provides an opportunity to review and optimize your investment portfolio by selling underperforming assets and potentially reinvesting in better opportunities. You have the flexibility to choose when and which investments to sell for tax loss harvesting, which allows you to align the strategy with your overall financial goals. Finally, selling investments with losses can help you reduce exposure to underperforming assets, potentially improving your overall portfolio risk management.

There are a few drawback to tax loss harvesting. First, buying and selling investments to harvest tax losses may incur transaction costs, including brokerage fees and potential bid-ask spreads. These costs can erode some of the tax savings. Additionally, the wash-sale rule can limit your flexibility in managing your portfolio. Lastly, there's a risk of overtrading -- in an attempt to harvest losses, investors may engage in excessive trading, which can lead to increased market exposure and potential losses.

Tax loss harvesting and direct indexing are often used together to enhance tax efficiency and investment customization for sophisticated investors.

With direct indexing, an investor constructs a portfolio by purchasing individual stocks or bonds that make up a specific market index, such as the S&P 500, rather than investing in a corresponding index mutual fund or exchange-traded fund (ETF). This allows investors to have more control and customization over their portfolios. They can tailor their holdings to align with their specific preferences, values, or tax considerations.

Here's how direct indexing is related to tax loss harvesting.

Customized Portfolio Construction

Direct indexing provides the flexibility to customize your portfolio by selecting individual securities. This customization can be particularly useful for tax loss harvesting because it allows you to strategically choose which holdings to sell to realize losses while keeping others intact. This level of control is not possible with traditional index funds or ETFs, where you don't have direct ownership of individual securities.

Enhanced Tax Efficiency

By combining direct indexing with tax loss harvesting, you can optimize your portfolio for tax efficiency. You can actively manage your holdings to harvest tax losses when opportunities arise, such as during market downturns or when specific stocks or bonds underperform. This can result in a more tax-efficient investment strategy compared to simply holding a passive index fund.

Reduced Tracking Error

Direct indexing aims to closely replicate the performance of a market index while allowing for customization. When tax loss harvesting is applied with a direct indexing strategy, you can potentially minimize tracking error (the difference in performance between their customized portfolio and the benchmark index) because they can strategically choose which assets to buy and sell for tax purposes.

Both direct indexing and tax loss harvesting require careful planning and monitoring to be effective. At Chicago Partners, we work with sophisticated investors to ensure these strategies are implemented correctly and are in line with our clients' financial goals and tax situations.

To learn more about tax loss harvesting and other tax planning strategies, you can send a message to one of our advisors here.