Market losses could potentially present an opportunity of sorts for investors willing to handle a portfolio’s downside strategically.
How? Through a process called “tax-loss harvesting.”
Before considering this potential tax-saving move, we recommend speaking with a financial advisor, who could help you find the tax strategy that makes the most sense for your financial situation.
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A 2022 Northwestern Mutual study found that 62% of U.S. adults admit their financial planning needs improvement. However, only 35% of Americans work with a financial advisor.1
The value of working with a financial advisor varies by person. While advisors are legally prohibited from promising returns, research suggests that people who work with a financial advisor feel more at ease about their finances and could end up with about 15% more money to spend in retirement.2
What is Tax-Loss Harvesting?
Tax-loss harvesting is a way of using your investment losses to lower your taxes on capital gains. Basically, it shows the IRS that while you made money from some investments, you lost money from others. Therefore, you don’t owe as much in taxes.
The process of tax-loss investing involves selling assets at a loss and buying similar investments. It allows you to take advantage of your losses for tax purposes and maintain your desired asset allocation.
Below, we’ll show you the hypothetical impact that tax-loss harvesting can have on an investor’s bottom line.
For help with tax-loss harvesting and other portfolio moves, consider working with a financial advisor. Click here to get matched with up to three fiduciary financial advisors who serve your area, each obligated to work in your best interest.
Hypothetical Scenario 1: Investment Losses Aren’t Harvested
Imagine a hypothetical scenario in which an imaginary investor, Kevin, sells enough stock to produce $60,000 worth of capital gains in a given year. Please keep in mind that hypothetical scenarios do not represent actual performance, were not achieved by any investor, and actual results may vary substantially.
However, not all of Kevin’s investments have been winners. He also has a stock in his portfolio that has gone down in value since he purchased it several years earlier. If he were to sell that stock today, he would take a $30,000 loss. Instead of offloading his losing position, Kevin hopes that it will rebound.
Kevin has a high income and is subject to a 20% long-term capital gains tax rate. As a result, he has a tax liability of $12,000 associated with his $60,000 in capital gains ($60,000 x 20%). After paying taxes on the gains, he’s left with a $18,000 net profit (realized and unrealized) across his two investments.
Hypothetical Scenario 2: Investment Losses Offset Gains
Now consider a scenario in which a hypothetical investor named Kim uses investment losses to offset some of her capital gains. Again, keep in mind that hypothetical scenarios do not represent actual performance, were not achieved by any investor, and actual results may vary substantially.
Kim’s investments don’t perform quite as well as Kevin’s, but she’s still able to generate $55,000 in long-term capital gains over the course of the year. And like Kevin, Kim also has $30,000 of investment losses in her portfolio.
However, Kim opts to sell these losing investments. Selling at a loss stings, but lowers her realized capital gains by $30,000. As a result, she only pays taxes on her net capital gain, $25,000. Harvesting her losses lowers her tax bill to just $5,000, meaning she’s left with $20,000 after paying the IRS.
Despite her investments underperforming compared to Kevin’s, Kim hypothetically ends up with more money because she harnessed the power of tax-loss harvesting.
Does Tax-Loss Harvesting Make Sense for You?
As you can see, harvesting investment losses for tax purposes can be a savvy portfolio move. However, it relies on accepting the reality that a previous investment did not pan out, and as a result, cutting your losses.
Since everyone’s financial situation is unique, to determine if this is an investment strategy you should consider, we recommend speaking with a financial advisor.
A fiduciary financial advisor could help you consider not only the tax implications of a move, but also other factors specific to your situation.
Not sure where to start? We created a free quiz to help Americans find vetted financial advisors who serve their area.
This quiz asks you a few questions, then matches you with up to three fiduciary financial advisors. You even earn a free consultation with each of your matches, so you can compare them and be fully prepared to pick a financial advisor.