Selling investments that have lost value can be a useful tax-reduction strategy for investors in any year. But it may be especially attractive this year in light of the late-summer stock market correction. The strategy, called tax-loss harvesting, means selling stocks, bonds, and mutual funds that have lost value to help reduce taxes on capital gains from winning investments. (Of course, you don’t want to undermine your long-term investing goals by selling an investment just for tax purposes.)
For investors who realized capital gains in 2015, August’s broad market sell-off may provide opportunities for offsetting a significant portion of those gains. Even if you don’t have gains, selling depreciated investments after a correction could generate losses that can be carried forward to offset gains in future years or can reduce ordinary income in the current year by up to $3,000.
Tax-loss harvesting can be beneficial for active traders, as well as those who perform an annual portfolio rebalancing. Rebalancing is a key to ensuring your investment mix (stocks, bonds, and short-term investments) is aligned to your investment time frame, financial needs, and comfort with volatility. This year, because of the correction, portfolio rebalancing may generate opportunities for tax savings in addition to bringing your holdings back in line with your investment goals.
Whatever type of investor you are, planning ahead and starting early to evaluate a tax-loss harvesting strategy can help you maximize the potential benefits.
How much can you save with tax-loss harvesting?
The size of the potential benefit from tax-loss harvesting depends on your income level and the amount of your short- and long-term capital gains, minus any current losses that you may have already realized or any losses carried forward from other years.
Short-term capital gains are those realized from investments that you have owned for one year or less, and they’re taxed at the marginal rate you pay on ordinary income. The top marginal tax rate on ordinary income is 39.6%. For 2015, it applies to couples filing jointly with income above $464,850, and single taxpayers with income above $413,200. For those subject to the net investment income tax (NIIT), which is 3.8%, the effective rate can be as high as 43.4%. And with state and local income taxes added in, the rates can become even higher.
Long-term capital gains, those realized from investments held for more than a year, are taxed at significantly lower rates. You won’t owe any long-term capital gains tax if your 2015 taxable income is below $74,900 and you are married filing jointly, or $37,450 if you are a single filer. For the majority of taxpayers—those with taxable income between $74,901 and $464,850 (married, joint filers) and $37,451 and $413,200 (single filers)—the long-term capital gains rate is 15%.
High-income taxpayers, on the other hand, are subject to higher rates. If your taxable income is more than $464,850 (married joint filers), or $413,200 (single filers), your marginal rate for long-term capital gains is at least 20%.
Again, when the 3.8% NIIT comes into play, the actual long-term capital gains tax rate for high earners can be as much as 23.8%, and the actual rate applied to other investment income can be as high as 43.4%. The NIIT is levied on the lesser of net investment income or the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for couples filing jointly, and $200,000 for single filers.
For example, a couple with MAGI of $270,000, of which $50,000 was net investment income, would owe the 3.8% surtax on $20,000 (the amount by which their MAGI exceeded the $250,000 threshold, which is less than the $50,000 in net investment income). If the couple had $330,000 in MAGI, of which $50,000 was net investment income, they would pay the surtax on $50,000 (the amount of their net investment income, which is less than the $80,000 excess of their MAGI over the $250,000 threshold).
Prioritizing your tax savings
To help maximize your tax savings, you should apply as much of your capital loss as possible to short-term gains, because they are taxed at a higher marginal rate. This is particularly true for high-income investors.
For example, if you’re in the top tax bracket, the difference between short- and long-term gains can be as high as 19.6% (43.4% versus 23.8%). However, if you’re in the 25% tax bracket—$74,901 to $151,200 for joint filers and $37,451 to $90,750 for singles—the difference between the short- and long-term gains rate is 10% (25% versus 15%).
According to the tax code, short- and long-term losses must be used first to offset gains of the same type. But if your losses of one type exceed your gains of the same type, then you can apply the excess to the other type. For example, if you were to sell a long-term investment at a $15,000 loss but had only $5,000 in long-term gains for the year, you could apply the $10,000 excess to any short-term gains.
Realizing a capital loss can be effective even if you didn’t have realized capital gains of either type this year. The tax code allows you to apply up to $3,000 a year in capital losses to reduce ordinary income, which is taxed at the same rate as short-term capital gains and nonqualified dividends. If you still have capital losses after applying them first to capital gains and then to ordinary income, you can carry them forward for use in future years.
The least effective implementation of a tax-loss harvesting strategy, on the other hand, would be to apply short-term capital losses to long-term capital gains. But, depending on the circumstances, that may still be preferred over paying the long-term capital gains tax.
Keep in mind
Don’t let lowering your current-year taxes undermine a diversified investment portfolio. A tax-loss harvesting strategy should always fit with your overall investment strategy. Good candidates for tax-loss harvesting are depreciated investments that no longer fit your strategy, that have poor prospects for future growth, or that can be replaced by other investments that are similar (but not exact matches) to the ones you are considering selling.
It is possible to sell a depreciated investment that you still want in your portfolio by investing the proceeds from the sale in another asset that is not “substantially identical” (as defined by the IRS), then selling it and buying back the original investment more than 30 days after the sale date. If you repurchase the investment too soon or invest in something the IRS deems substantially identical to the original security, such as a call option on it, the IRS “wash sale” rule will generally disallow the loss deduction. There’s also a risk that the substitute investment you buy will increase in value during the 30-day waiting period, and you’ll realize a short-term gain if you sell it. On the other hand, if the substitute does not rise in price over the 31-plus-day period, but the original asset does, you may miss out on some of the gain.
If you want to maintain exposure to the industry covered by the stock you held at a loss, you might consider substituting an exchange-traded fund (ETF) that targets that industry, after making a tax-loss harvest sale. Read Viewpoints: “Tax-loss harvesting using ETFs.”
What to do now—and next year
If you plan to implement a tax-loss harvesting strategy to offset a portion of your gains, be sure to research your records carefully on any asset you are considering selling. You’ll want to be certain about the cost basis (the price you paid to purchase a security plus any additional costs, such as broker’s fees or commissions) of your depreciated investments—which determines the extent of your loss—before you make your move. To check the amount of capital gains and losses in your nonretirement Fidelity accounts—and determine whether they’re short term or long term—use our tax loss harvesting tool (login required).
Also, take some time to determine how changes in the value of your investments within your portfolio have affected your mix of investments. Routine portfolio rebalancing is recommended for keeping your portfolio aligned with your goals. It often provides an opportunity to reexamine lagging performers that could be candidates for tax-loss harvesting.
Ideally, tax planning should be a year-round activity, and that includes tax-loss harvesting. Keeping good records will help you track your cost basis and anticipate any capital gains tax liability long before the end of the year.
Also keep in mind that selling a depreciated investment that no longer has a place in your portfolio can be a good move even if you don’t anticipate having capital gains to offset it. You can use the proceeds to invest in something with better prospects that may better suit your needs. The loss can be used to lower your tax bill through reducing ordinary income by $3,000, or carried over into future years if not needed immediately.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917