By Dan Hunt, Senior Investment strategist
Call me an optimist, but I like to see the positive side in things. Most people are unhappy when their investments decrease in value, and I’m no exception. But I keep a silver lining in mind: My investment losses can potentially become tax benefits through a process called tax-loss harvesting.
While many investors focus on tax-loss harvesting toward year end, it’s a powerful strategy that can help you year-round. That’s particularly true during times of market volatility, as we’ve seen in the past few years.
Tax-loss harvesting: How does it work?
Tax-loss harvesting is a tax-efficient investing strategy that allows you to sell down assets to help reduce the amount of current taxes you have to pay on your investments. Under current U.S. federal tax law, you can offset your capital gains with capital losses incurred during that tax year or carried over from a prior tax return. Capital gains are generally the profits you realize when you sell an investment for more than you paid for it, and capital losses are generally the losses you realize when you sell an investment for less than you paid for it.
Since U.S. investors must pay taxes on net capital gains, offsetting capital gains with capital losses can lower your taxable income (provided you’re a U.S. taxpayer). Let’s say I earn a profit of $30,000 by selling Fund A. Meanwhile, I notice that Fund B is down by $15,000. By selling Fund B, I can usually use those capital losses to partially offset my capital gains from Fund A—meaning I’d only owe taxes on $15,000 of profit instead of $30,000.
“Harvesting” that $15,000 loss, in this case, would have no effect on my portfolio’s value, and I could use the proceeds to buy a similar investment, subject to the "wash sale” rules. That would allow me to maintain roughly the same asset allocation while reducing my federal income taxes, leaving me with additional funds that would remain in my investment account continuing to earn investment gains.
Your losses don’t just offset your gains; they can also offset up to $3,000 of ordinary income each taxable year. Let’s say I still realized a profit of $30,000 from Fund A. But in this scenario, Fund B lost $33,000. Assuming I had no other capital gains or losses for the year, I could use my loss to offset my entire gain from Security A, plus I could offset $3,000 of my ordinary income, further reducing my current income tax liability, or possibly increasing my tax refund. If your losses are higher than both your capital gains and $3,000 in income, you can carry those losses forward and use them in future tax years.
One thing to watch out for: wash sales
You’ll want to make sure you don’t inadvertently participate in a “wash sale,” which occurs when you sell or trade stock or securities at a loss and buy the same or substantially identical stock or securities within 30 days before or after the sale. Basically, it says that I can’t sell Security B and then immediately buy it back again just to get the tax benefit, and if I do so, I must defer the capital loss. I am, however, allowed to claim the loss currently if I sell one stock and buy another one in the same industry—just not stock in the same exact company as before, or another investment the IRS would consider “substantially identical” to the one I sold.
Another thing to watch out for: short-term capital gains
The government incentivizes people to invest for the long-term rather than constantly buying and selling on ephemeral news. It does this by taxing short-term capital gains (profits made from selling investments held for a year or less) at a higher rate than long-term capital gains (profits from investments held longer than a year). So, offsetting short-term investment gains with losses can have a particularly high impact on your tax bill. Under current tax law, you’ll owe the tax rate on long-term capital gains (the maximum rate is 20 percent), while short-term capital gains get taxed at your regular income tax rate.
Tax-loss harvesting can make a bigger difference if you trade a lot, or have invested in strategies with higher turnover and, thus, more short-term gains. Note that there are certain rules in the Internal Revenue Code that dictate whether specific capital losses offset short- versus long-term capital gains.
With Total Tax 365, your Financial Advisor can integrate tax-aware strategies into your investment plan to help you mitigate capital gains tax in your portfolio while managing risk.
In addition, if you have complex tax planning needs, your Morgan Stanley Financial Advisor can connect you to experienced tax professionals at leading U.S.-based providers across the country to help optimize your tax strategy. Connect with your Morgan Stanley Financial Advisor to learn more.
Of course, there’s no guarantee that tax-loss harvesting will achieve any particular tax result, or that it’s necessarily the best thing for you. Before implementing any tax strategy, check with your accountant or other U.S. tax advisor.