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Understanding Tax-Loss Harvesting

Written by Rick Imhoff CFP®, Senior Financial Planner, WMG Officer

In its simplest form, tax-loss harvesting is a strategy to help reduce your tax liability and improve your overall investment results in taxable brokerage and investment accounts, typically involving stocks, bonds, exchange traded funds, and mutual funds.  The main benefit of realizing a loss is that it can be used to offset realized capital gains dollar-for-dollar, reducing the taxable portion of the profits made on other investment sales.  If the losses are greater than the gains, you can take up to $3,000 in losses per year to offset ordinary income.  Any excess above $3,000 can be carried forward in future tax years.

Some investors have difficulty in taking a loss on an investment that has declined in value.  They want to hold onto the investment until it gets back to what they paid for it and then sell it.  This thought process is mostly emotional, which should not be a part of an investor’s decision making.

Let’s say an investor bought 100 shares of XYZ stock at $200 per share for a $20,000 investment.  Two years later, the stock declined 50% in value to $100 per share, making the 100 shares worth $10,000 for an unrealized loss of $10,000.  For those investors who make the emotional decision to hold onto XYZ stock until it reached the $200 per share price originally paid for it, XYZ stock would have to appreciate 100%, which is double in price, to reach that point.  Depending on the reason for the stock decline, the stock may take years to get back to what was paid for the stock.

If the investor believes the fundamentals of XYZ stock are solid and will increase in value over time, it would be beneficial to sell XYZ stock, realize the $10,000 loss, wait at least 30 days to avoid the wash sale rule and buy the same 100 shares of XYZ stock at $100 per share (assuming no change in the price per share over that 30 days).  This lowers the investor’s cost per share in the stock and if the stock does appreciate, you can see a profit in the stock much sooner than waiting for it to double in value just to get back to the original cost basis.  If the investor decides the stock is no longer desirable for their portfolio, the net sale proceeds can be repositioned into a more promising stock.

In addition, the investor can deduct up to $3,000 of realized long term capital loss to offset other taxable income, which can help to recoup some of the loss, which could be substantial depending on the investor’s income tax bracket.  This would also leave $7,000 of realized long term capital loss to carry forward into the following tax years.

This strategy can also be helpful to offset significant gains in an investment you desire to sell to either take profits because you think it has run its course or has become a concentration in your portfolio.  The current and future realized tax losses can be helpful to minimize the tax on realized capital gains.

Tax-loss harvesting can be a useful investment strategy to reduce your tax liability and to reposition your portfolio for better investment ideas or to help lower your cost basis on investments you desire to keep.  It also helps to take some emotion out of your investment decisions and not have to see that loss on your statement for several months or even years.

Rick Imhoff, CFP® is Senior Financial Planner & Wealth Management Officer for the MidAmerica National Bank Wealth Management Group and he can be reached at rimhoff@midnatbank.com or (309) 647-5000 ext. 1130