The Pros and Cons of Annual Tax-Loss Harvesting

Many investors undertake tax-loss harvesting at the end of every tax year. The strategy involves selling stocks, mutual funds, exchange-traded funds (ETFs), and other investments carrying a loss to offset realized gains from other investments. It can have a big tax benefit.

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

Newest Tax Rates

The Internal Revenue Service (IRS), many states, and some cities assess taxes on individuals and businesses. At times, the tax rate—the percentage for the calculation of taxes due—changes. Knowing the latest rates regarding investments helps you decide if tax-loss harvesting is smart for you now.

For the 2022 and 2023 tax years, federal tax rates that are pertinent to tax-loss harvesting include:

• A top tax rate of 20% for long-term capital gains. Depending on your income, the rates are 0%, 15%, or 20%, and the IRS notes that most individuals pay no more than 15%.
• A Medicare surtax for high-income taxpayers that is 3.8% of investment income for taxpayers whose overall income exceeds $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for individuals.
• An ordinary income tax rate that tops out at 37%. Depending on your income, your tax rate will be 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

All investors may deduct a portion of investment losses, but these rates make investment losses more valuable to high-income investors who use them.

Understand the Wash-Sale 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 buy back the same asset—or another asset that is “substantially identical”—for 30 days.

In the case of an individual stock and some other holdings, this rule is clear. If you had a loss in Exxon Mobil Corp., for instance, and wanted to realize that loss, you would have to wait 30 days before buying Exxon Mobil stock. (This rule can actually extend to as much as 61 days: You would need to wait at least 30 days from the initial purchase date to sell and realize the loss, and then you need to wait at least 31 days before repurchasing that identical asset.)

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

Many investors use index funds and exchange-traded funds (ETFs), as well as sector funds, to replace stocks they have sold while avoiding violating the wash-sale rule. This method may work but can also backfire for any number of reasons: extreme short-term gains in the substitute security purchased, for example, or if the stock or fund sold appreciates greatly before you have a chance to buy it back.

You also cannot avoid the wash-sale rule by buying back the sold asset in another account you hold, such as an individual retirement account (IRA).

Portfolio Rebalancing

One of the best reasons for tax-loss harvesting is to use it in the context of rebalancing your portfolio. Rebalancing means adjusting your assets back to your chosen mix of risk and reward after the gyrations of the markets have knocked it off-kilter.

As you rebalance, look at which holdings to buy and sell, and pay attention to the cost basis (the adjusted, original purchase value). The cost basis will determine the capital gains or losses on each asset.

You don’t want to sell just to realize a tax loss if it does not fit your investment strategy.

A Bigger Tax Bill Down the Road?

Some contend that consistent tax-loss harvesting with the intent to repurchase the sold asset after the wash-sale waiting period will ultimately drive your overall cost basis lower and result in a larger capital gain to be paid in the future.

This could well be true if the investment grows over time and your capital gain gets larger—or if you guess wrong regarding what will happen with future capital gains tax rates. 

Yet your 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 must pay later.

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

All Capital Gains Are Not Created Equal

Short-term capital gains are realized from investments that you hold for a year or less. Gains from these short holdings are taxed at your marginal tax rate for ordinary income. The Tax Cuts and Jobs Act set the current income rate brackets, from 10% to 37% depending on income and how you file, until 2025 when it might be revised or extended.

Long-term capital gains are profits from investments you hold for more than a year, and they’re subject to a significantly lower tax rate. For many investors, the rate on these gains is around 15% (the lowest rate is zero and the highest, 20%, with few exceptions).

For the highest income brackets, the additional 3.8% Medicare surtax on investment income comes into play.

You should first offset losses for a given type of holding against 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 of the long-term losses, the balance of long-term losses can go toward offsetting short-term gains, and vice versa.

Maybe you had a terrible year and still have losses that did not offset gains. Leftover investment losses up to $3,000 can be deducted against other income in a given tax year with the rest being carried over to subsequent years.

Certainly, one consideration in the tax-loss harvesting decision in a given year is the nature of your gains and losses. You will want to analyze this or talk to your tax accountant.

Mutual Fund Distributions

With the stock market gains over the past few years, many mutual funds have been throwing off sizable distributions, some of which are in the form of both long- and short-term capital gains. These distributions also should factor into your equations on tax-loss harvesting.

The Bottom Line

It’s generally a poor decision to sell an investment, even one with a loss, solely for tax reasons. Nevertheless, tax-loss harvesting can be a useful part of your overall financial planning and investment strategy and should be one tactic toward achieving your financial goals.