2020 has been a year of clear winners and losers in the stock market. That makes this year an important one to consider tax-loss harvesting for taxable portfolios. Here’s how that may impact you.
A Quick Primer on Tax-Loss Harvesting
First off, this is only generally relevant to taxable accounts. If you have a 401(k) or IRA, for example, then your investments are generally tax-deferred so this topic is less relevant. However, if you do pay tax on your investment gains and losses, then tax-loss harvesting can matter. It can be useful to take investment losses within the first year of purchasing a stock. This may help in a few ways.
Firstly, those losses may get you a tax deduction. Depending on your tax-filing status, you may be able to take $3,000 of investment losses on your tax return. However, paper losses don’t count, you must realize those loses by selling losing stocks.
Secondly, if can’t realize a loss, you may still get a tax reduction. If you have material investment gains, then selling some losing stocks before the end of the year could reduce the taxes you owe. Of course, this may seem pointless, you are not avoiding tax, just deferring it.
However, when investing, holding onto your money for longer does have the potential to increase your returns under certain assumptions, even if you do ultimately pay the tax in the end.
This is because you earn a return on the money that would have gone to the IRS for a longer period of time. Also, long-term capital gains are generally taxed at a lower rate than short-term gains. Hence taking losses early can be prudent.
However, ideally you don’t necessarily want to change your portfolio just for tax reasons. This is where wash trades come in. If you sell an investment for tax reasons and then just buy it back again, the IRS will generally call it a wash trade and you won’t get the tax benefit. There are a few approaches you can tax here, though as with all of these you should consult a tax expert depending on your circumstances. Firstly, if you sell an investment and wait over 30 days before buying it back then a wash trade is unlikely to be triggered. Secondly, you could sell one investment, say Coca-Cola, and then swap into something broadly equivalent, say Pepsi, and that should not fall foul of the IRS. That said the new investment must not be substantially identical, though the IRS is not absolutely clear on how that terms should be defined.
One reason to think about tax-loss harvesting right now, is that many other investors consider the strategy in late December, at the end of the tax year. When investing you don’t necessarily want to be following the crowd. There’s some indication that all the year-end tax-loss harvesting can move the markets. It can push prices of losing stocks down around year-end, and drive winners up, only for the reverse to occur in January. Hence tax-loss harvesting may support the January effect, where value stocks tend to have a strong January, and momentum stocks lag.
This means that if you are tax-loss harvesting, you may miss out on a potential January bounce for the stocks you are selling, if you are out of the market then to avoid a wash trade.
That could be a reason to think about tax-loss harvesting now. Equally, many investment services do now have tax-loss harvesting features built-in, so if you are using an investment service you may already be covered. Still, if you’re investing for yourself there may be some tax-efficiency to be realized from considering your options. Tax-loss harvesting is one area where it can be prudent to be early.