Mark Twain said, “The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.”
In the polarized world that we live in, it’s often hard to find common ground with those around us. It seems, however, that many can find common ground in the belief that the taxes we pay are too much. Strategies to minimize our tax liability are sought after, almost like gold during the gold rush.
Tax-loss harvesting is an interesting strategy that not only intends to decrease one’s tax liability but could potentially boost portfolio returns. The strategy involves assuming losses intentionally to offset capital gains or ordinary income. Here, our Boise tax planning professionals discuss tax-loss harvesting and other portfolio-building strategies you should consider.
Basic things to understand before considering tax-loss harvesting:
- You can only harvest losses in taxable accounts. Because most retirement accounts grow tax-deferred, they are not subject to capital gains.
- Capital losses can be used to offset capital gains or ordinary income. For 2021, a married couple filing jointly can deduct up to $3,000 against ordinary income. The remaining capital loss can be carried forward to future years.
- The losses have to be realized losses. This means that a transaction must be made where the investor sustained a loss. A security may have lost value during the year. However, the loss is still considered unrealized until the security is sold.
- For capital losses to be tax-deductible, the investor can’t be involved in what’s called a “wash sale.”
What is a wash sale?
Wash sales are extremely important to understand before engaging in tax-loss harvesting. Wash sales were added to the tax code to prohibit investors from avoiding taxes by selling securities, sustaining losses, and then buying those same securities back even on the same day.
When the loophole was discovered by lawmakers, the wash sale was born. The IRS details that a wash sale occurs when selling or trading stock or securities at a loss and that, within 30 days before or after the sale, you:
- Purchase substantially identical stock or securities,
- Procure substantially identical stock or securities in a fully taxable trade,
- Procure a contract or option to buy substantially identical stock or securities, or
- Procure substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.
There’s ambiguity in what replacement securities can and can’t be. What constitutes a substantially identical security? Because of the vagueness of the tax law, it’s important to seek guidance from a professional when buying replacement securities.
What’s the big deal?
Tax-loss harvesting can help boost after-tax returns and could increase asset accumulation over a period of time.
Dr. Horstmeyer, a professor of finance at George Mason University’s Business School, conducted research to determine just how beneficial this strategy might be. His research—which consisted of running simulations over different types of portfolios and scenarios—found that an investor that has a 25% capital gains tax rate could possibly add around 1.1-1.42% to their portfolio through tax-loss harvesting.
Likewise, a study done through Vanguard revealed similar results. The study observed more than 80,000 investors of different portfolio types and found that tax-loss harvesting could add just over 1% in returns to an investor’s portfolio. Although returns can never be guaranteed, research does indicate that tax-loss harvesting adds value to an investor’s portfolio, especially when the investor faces high capital gains tax rates.
Uncertainty with future capital gains tax rates has urged investors to seek out different ways to limit their tax liability while still accumulating wealth. If you have similar concerns, perhaps tax-loss harvesting could be a strategy to consider. Be sure to consult with a professional before implementing any such strategy.
IMAFS is among the top medical wealth management firms in Boise, ID. Our fee-only financial planners are dedicated to helping physicians and other healthcare personnel pave the path towards financial success. To learn more, schedule an appointment with one of our advisors today.