Tax-loss harvesting: how it works and when to consider it

By Jamie Viceconte, Head of Investment Product | Citizens Wealth Management

^{Jamie joined Citizens Wealth Management in 2022 and is responsible for the curation and management of the investment product suite of ETFs and mutual funds, and portfolio models constructed with these products. As a strategic partner, he has over 30 years of experience in financial markets focused on a broad array of public and private equity and fixed income products.}

While market volatility and downturns can be unsettling, they can also create opportunities.

When investments decline in value, investors may be able to realize losses in a strategic way that offsets capital gains and potentially reduces taxable income. Known as tax-loss harvesting, here's how the strategy works, the potential benefits and when it may make sense to consider using it.

How tax-loss harvesting works

Tax-loss harvesting is the practice of selling an investment for less than its original purchase price (referred to as the cost basis) to realize a capital loss. The loss can be used to offset realized capital gains from other investments. Subject to defined annual limits, realized losses can also reduce ordinary taxable income.

To maintain your market exposure, proceeds from the sale of the position with the loss being realized, or harvested, can be reinvested in a similar security or fund.

For instance, you could sell shares of a S&P 500 mutual fund for a loss and buy shares of a Russell 1000 fund, another fund that tracks the stock performance of large capitalization U.S. companies. This provides an immediate tax deduction while maintaining similar market exposure.

Understanding capital gains and losses

To understand tax-loss harvesting, it's important to know how the IRS treats investment gains and losses.

A capital gain is realized when an asset is sold for more than its cost basis. The gain is taxed differently depending on the length of time the asset was held.

If the asset was held for less than one year, it is treated as a short-term capital gain. Short-term capital gains are usually taxed at your ordinary income tax rate, which ranges from 10% to 37% depending on filing status and income.¹

If the asset was held for more than one year, it is treated as a long-term capital gain and, with few exceptions, taxed at a tax rate of either 0%, 15% or 20% depending on filing status and income.²

A capital loss is when an asset is sold for less than its cost basis. Capital losses are applied against capital gains in this order:

• Short-term losses offset short-term gains.
• Long-term losses offset long-term gains.
• Remaining losses are then used to offset capital gains of the opposite type.

If losses exceed gains, up to $3,000 of losses can be deducted against ordinary income in the current tax year. Any unused losses can then be carried to future tax years.

Potential benefits of tax-loss harvesting

When used strategically, tax-loss harvesting can offer several potential benefits:

• Reduce capital gains and taxable income: The primary benefit is the application of losses to offset capital gains, with residual losses available to reduce ordinary taxable income.
• Offset taxes on other asset sales: Losses can also be applied to gains from the sale of a business, real estate, or other investments.
• Stay aligned with your investment strategy: Reinvesting the proceeds from the sale of an asset with a realized loss into a similar asset may allow you to maintain your long-term investment approach while realizing tax benefits.
• Leverage market downturns: Volatility can create opportunities to harvest losses that may not be available in more stable markets.

Risks and limitations of tax-loss harvesting

Tax-loss harvesting does have limitations that need to be thoroughly understood and considered before moving forward. Here are a few key considerations:

• Beware of the wash sale rule: A wash sale occurs when the security sold for tax-loss purposes, or one considered "substantially identical," is repurchased within 30 calendar days before or after the sale. A wash sale voids the use of the loss for tax purposes and resets the clock on the required 30-day waiting period for repurchasing the security. This applies to purchases in any of your accounts, including IRAs.
• Use only in taxable accounts: You can't harvest losses in tax-advantaged accounts like IRAs and 401(k)s.
• Be aware of market timing risk: Delaying reinvestment of the proceeds from tax-loss harvesting could mean missing a market rebound.
• Understand opportunity cost: When reinvesting funds, the replacement investment could underperform the original investment going forward.
• Follow current tax rules: Tax regulations are complex and evolve over time. Future changes could impact the availability or effectiveness of this strategy, so it's important to consult a tax professional and financial advisor to ensure you use tax-loss harvesting properly.

When to consider tax-loss harvesting

You and your financial advisor can review your portfolio for potential tax-loss harvesting opportunities. Here are situations where it may be useful:

• If you have unrealized losses: Your portfolio may have more opportunities for tax-loss harvesting during market downturns. Be flexible with your timing as opportunities may not always line up perfectly with year-end planning.
• If you have large capital gains: Tax-loss harvesting can be especially useful during years when you have considerable capital gains from selling investments, real estate, a business, or other assets.
• If you're in a high tax bracket: The higher your marginal income tax bracket, the greater the impact of tax-loss harvesting.

Is tax-loss harvesting right for you?

While tax-loss harvesting is a strategy that could help you reduce your tax liability, it should be considered within a disciplined investment framework. It is not a guaranteed way to increase returns or avoid losses and it should not singularly drive investment decisions. Instead, it works best when it aligns with a comprehensive plan that is based on your long-term investment strategy and goals.

Like tax-loss harvesting, effectively managing your investments can be complex. If you're looking for professional guidance, consider speaking with a Citizens Wealth Advisor* to create a personalized investment plan based on your financial goals. The right plan today can help you prepare for your future with confidence.

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