- Gains in taxable accounts are subject to capital gains taxes or income taxes.
- Tax-loss selling or tax-loss harvesting involves realizing losses to offset gains.
- A tax-loss selling strategy requires following specific rules.
- Selling can have long-term implications, so make your decisions carefully.
Gains have been tougher to come by this year than in previous years, given the bear market has taken a toll on stocks and bonds. Still, plenty of scenarios could have led investors to book profits that could result in a tax bill in 2023.
For example, many likely booked gains when the stock and bond markets broke below critical support earlier this year to protect profits or reduce market exposure. Others accurately timed the commodity rally, racking up short-term realized gains in energy stocks. Margin calls may also have forced some to sell some stocks at a gain.
Regardless of the reason, if you have gains in taxable accounts because of sales this year, now is the time to look at your portfolio to see if any unrealized losses can be used to offset them. This tax-loss harvesting can lower your tax bill, but some pitfalls must be avoided.
What is tax-loss harvesting?
A Tax-loss harvesting strategy involves selling investments at a loss to offset realized gains, reducing your tax liability.
If you're investing using a taxable account rather than a tax-advantaged one, such as a 401k, you may have to pay a substantial share of your investment gain at tax time.
Investments held for less than one year are considered short-term investments, so they're taxed at your ordinary income tax rate. Gains on long-term investments held over one year are taxed at 0%, 15%, or 20%, depending on your income and tax filing status.
Since the U.S. uses a marginal tax rate system, a higher tax rate is applied at specific income levels for each additional dollar earned. In 2022, the tax brackets for married couples filing jointly increase from as low as 10% for up to $20,550 in income to as much as 37% for income above $647,850.
Depending on where you fall on the tax bracket, the tax on realized investment gains can add up. For instance, if your household income is between $178,151 to $340,100, then 24% of your profit could be owed to the IRS.
That's a lot of money that can't be reinvested into another idea. Reducing or eliminating tax liability by offsetting gains with losses is valuable, especially if doing so drops you into a lower tax bracket.
A tax-loss strategy
Real Money Pro's Peter Tchir recently discussed how he's approaching tax loss harvesting this year. He writes:
“I'm not worried about long-term capital gains. I'm OK with the tax rate there…I'm focused on reducing my realized gains and think my muni closed-end funds portfolio is the best place to do that…have liked the muni closed-end fund space throughout most of the year and continually have been buying (up until September or so for myself). My overall position is underwater, but after the recent rally, I have positions that are both up and down money…I'm selling some of the biggest percentage losers I bought this year. I want the short-term loss.”
Tchir's game plan is to evaluate a group of similar investments (in this case, closed-end municipal bond funds), selling the largest losers. Tchir still wants to own the same amount of these funds, but he'll need to buy other funds with the proceeds to avoid the IRS' wash-sale rule.
A wash sale occurs when an investment is sold to take a loss to offset gains, but the same or substantially identical security is bought within 30 days before or after the sale. The IRS instituted the wash sale rule to prevent investors from artificially recording losses to eliminate their tax liability. Tchir writes:
“The nice thing about the closed-end fund space, on the muni side, is there are plenty of other ones to invest in. I want to keep my overall exposure about the same, so I will be selling some muni closed-end funds to buy others, which should not trigger a wash sale.”
Since there are many funds in this category, Tchir can find alternatives that aren't identical to the funds he sold, allowing him to sidestep the wash sale rule.
Although Tchir still likes these closed-end funds, he's no longer as comfortable with leveraged funds that may yield more but can result in bigger losses. For this reason, he is looking to his leveraged fund portfolio to harvest losses, and he plans to reinvest those proceeds differently.
“On the leveraged loan closed-end fund side of the equation, I've been scaling back and will harvest more tax losses here, but will largely be taking money off the table. I'm thinking 3-to-1 is a good ratio of selling to buying in this space right now.”
The takeaway is that Tchir isn't selling willy-nilly. Instead, he's analyzing his holdings to determine what he wants to own or sell and being thoughtful about the total exposure he wants after his sales are complete.
A similar approach could be used with other investments. For example, suppose an investor wishes to maintain similar exposure to semiconductors. They should evaluate the pros and cons of each semiconductor stock they own and only sell those they truly don't want to own (i.e., only selling those with a broken thesis for holding). If they wish to maintain the same weight in the basket, they could reposition proceeds into another individual stock in the same industry, such as a semiconductor equipment stock. Or, if they don't mind a more diversified alternative, they could buy a semiconductor ETF, such as the SPDR Semiconductor ETF (XSD) .
The Smart Play
Tax-loss selling is a valuable strategy. It produces tax savings on investment gains, allowing more money to remain invested rather than be paid to Uncle Sam.
However, there are some things to consider.
For example, in addition to avoiding wash sales, long-term losses are applied first to long-term gains, and short-term losses are applied first to short-term capital gains.
If losses exceed gains, up to $3,000 is tax deductible from income, further reducing your tax bill. So, consider selling an investment at a loss even if you don't have any realized gains. If losses exceed gains and the $3,000 income limit, they can be carried forward to offset future profits and income.
Remember, tax loss selling only applies to taxable accounts. You can't take a loss in a retirement account to offset a gain in a taxable account.
Also, the wash sale rules apply across all accounts. So, for example, you can't sell an investment in a taxable account, take the loss, and buy it within the wash sale period in a retirement account. Similarly, you can't buy stock in a spouse's account to avoid the wash sale requirement. But, again, you can consider buying another stock or an ETF to maintain exposure.
The potential to lower your tax bill makes tax-loss harvesting smart, but don't go crazy. During bear markets, it's easy to extrapolate the current negative market sentiment to the future, but historically, new highs on the S&P 500 have eventually followed every bear market. So if you sell something because you have a loss now, you could wind up missing out on much bigger gains later. It's tempting to think you'll repurchase the investment after the wash sale rules end, but that can be easier said than done. For example, many likely regretted selling Amazon for tax loss harvesting in 2001, given it rallied 387% in the following two years.
Finally, don't ignore a potential buy opportunity. Tax-loss selling can cause poor performers to sell off into year-end, but that pressure disappears when the calendar flips to next year. As a result, hunting for bargains among beaten-down companies could be wise this month, but remember, many stocks are down for a good reason, so only buy stocks you wouldn't mind owning if things worsen.