Many investors set out to reap tax losses at the end of each tax year. The strategy involves selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments at a loss to offset gains made on other investments. It can have a big tax advantage.

But harvesting tax losses may or may not be the best strategy for all investors for several reasons.

New tax rates

The Internal Revenue Service (IRS), many states, and some cities assess personal and business taxes. Sometimes the tax rate – the percentage for calculating the taxes due – changes. Knowing the latest investment rates helps you decide if tax loss harvesting is smart for you now.

For the 2020 tax year, the federal tax rates on potentially harvest-relevant items include: the maximum rate for long-term capital gains, 20%; the Medicare surtax for high-income investors, 3.8%; and the highest marginal rate for ordinary income, 37%.  

Although all investors can deduct a portion of investment losses, these rates make investment losses potentially more valuable to high-income investors.

Understanding the Wash-Sell Rule

The IRS follows the wash sale rule, which states that if you sell an investment to recognize and deduct that loss for tax purposes, you cannot repurchase that same asset – or another “substantially identical” investment asset. – for 30 days.

In the case of an individual stock and a few other holdings, this rule is clear. If you had a loss on Exxon Mobil Corp., for example, and wanted to realize that loss, you would have to wait 30 days before buying back the stock. (This rule can actually extend up to 61 days: you’ll have to wait at least 30 days from the original purchase date to sell and realize the loss, then you’ll have to wait at least 31 days before redeeming that same asset.)

Let’s look at a mutual fund. If you made a loss in the Vanguard 500 Index Fund, you could not immediately buy the SPDR S&P 500 ETF, which invests in the same index. You could probably buy the Vanguard Total Stock Market Index, which tracks a different index.

Many investors use index funds and ETFs, as well as sector funds, to replace stocks being sold and not violate the wash sale rule. This method can work, but can also backfire for a number of reasons: extreme short-term gains in the replacement security purchased, for example, or if the stock or fund being sold appreciates significantly before you don’t have the option of redeeming it.

Also, you cannot avoid the wash sale rule by redeeming the sold asset into another account you hold, such as an Individual Retirement Account (IRA).

Portfolio rebalancing

One of the best scenarios for tax loss reaping is whether you can do so as part of your portfolio rebalancing. Rebalancing realigns your asset allocation for a balance between return and risk. As you rebalance, review holdings to buy and sell, and pay attention to the base price (the original adjusted purchase value). The cost basis will determine the capital gains or losses on each asset.

This approach will prevent you from selling just to realize a tax loss which may or may not fit your investment strategy.

A bigger tax bill on the road?

Some argue that a consistent harvest of tax losses with the intention of repurchasing the sold asset after the wash sale waiting period will ultimately lower your overall cost and result in a larger capital gain to be paid to the owner. ‘coming. This may well be true if the investment grows over time and your capital gain increases, or if you are wrong about what will happen with future capital gains tax rates.

Still, the current tax savings might be enough to offset higher capital gains later. Consider the concept of present value, which says that a dollar of tax savings today is worth more than the additional tax you’ll have to pay later.

It depends on many factors, including inflation and future tax rates.

Capital gains are not created equal

Short-term capital gains are realized from investments you have held for one year or less. Gains from these overdrawn assets are taxed at your marginal tax rate for ordinary income. The Tax Cuts and Jobs Act sets seven rate brackets for 2020, from 10% to 37% depending on income and how you file.

Long-term capital gains are profits from investments you have held for more than a year, and they are subject to a significantly lower rate of tax. For many investors, the rate on these gains is around 15% (the lowest rate is zero and the highest is 20%, with some exceptions).For the highest income brackets, the additional Medicare surcharge of 3.8% kicks in.

You must first offset the losses of a given type of holding with the first gains of the same type (for example, long-term gains against long-term losses). If there are not enough long-term gains to offset all long-term losses, the balance of long-term losses can be used to offset short-term gains, and vice versa.

Maybe you had a terrible year and still have losses that haven’t made up for the gains. Remaining investment losses up to $3,000 can be set off against other income in a given tax year, with the remainder carried forward to subsequent years.

Certainly, one consideration in deciding whether to reap tax losses in any given year is the nature of your gains and losses. You will want to analyze this or speak to your tax accountant.

Mutual fund distributions

With stock market gains in recent years, many mutual funds have paid out large distributions, some in the form of long-term and short-term capital gains. These distributions should also factor into your tax loss harvesting equations.

The essential

It’s generally a bad decision to sell an investment, even at a loss, just for tax reasons. Nonetheless, tax loss harvesting can be a useful part of your overall financial planning and investment strategy, and should be a tactic for achieving your financial goals. If you have any questions, consult a financial or tax advisor.