Using Tax-Loss Harvesting to Help Minimize Taxes

Blog - 3 - 12 - 15

For investors in taxable portfolios, capital-gains taxes are a fact of life. But it’s possible to limit the impact of taxes by using a strategy known as
tax-loss harvesting.

Tax-loss harvesting involves selling losing investments, and using those realized losses to offset taxes on the gains from other investments or on ordinary income. At Steel Peak, we have long used tax-loss harvesting to help our clients, especially for those in higher income brackets, reap significant tax savings.

Tax-loss harvesting may appear to be a simple endeavor. Let’s say that an investor has accrued $10,000 of capital gains in a given year. By selling losing investments by the end of the tax year, he or she can neutralize up to $3,000 of the gain for tax purposes. Thus, just $7,000 of the gain is taxable.

If the investor harvests more than $3,000 in a year, the excess can be banked and used the following year. That sounds simple enough, but tax-loss selling can’t be done willy-nilly. For example, short-term losses (those from investments held for a year or less) must first be used to neutralize short-term gains. Long-term losses (from investments held for more than a year) must first be applied to long-term gains.

What’s more, it’s imperative that tax-loss harvesting decisions preserve the original design of your portfolio. After a tax-loss sale is made, it’s important to buy a similar type of investment relatively quickly (but not the same one—that will void your tax savings). In order to keep your portfolio consistent, the new investment should have the same characteristics as the old one in terms of risk, market cap and so on.

Tax-loss harvesting is often done toward the end of the year, as part of a general portfolio rebalancing. As you’ll recall, regular market fluctuations can upset your original balance of asset classes, as bonds grow in value while stocks decrease, for example.

The amount saved through tax-loss harvesting varies based on a client’s income level, amount of gains, and any losses carried forward from prior years.

One key to maximizing tax savings is to focus first on using losses to neutralize short-term gains, since these gains are taxed at a higher rate. The higher your income, the more important this is. For those in the top tax bracket, the gap between short- and long-term gains may be as high as 19.6%. For those in the 25% bracket, the difference is 10%.

Although tax-loss harvesting can be a powerful tax-reduction tool, it’s important not to let the tail wag the dog. Good tax-loss harvesting fits with one’s overall investment strategy; selling just to avoid taxes isn’t a good idea.

In looking for losing investments to “harvest,” we focus on those that may no longer fit a client’s strategy, or that have encountered serious, unexpected problems. In these cases, tax-loss harvesting allows us to replace a weak investment with a more promising one—and save you some money on taxes in the bargain. If you’d like to know more about tax-loss harvesting or any of our services, please don’t hesitate to get in touch.