Since 2022 has brought one of the worst starts in history for both the equity and fixed income markets, it makes sense to revisit the "silver lining" topic of the opportunity to reduce your tax liabilities. I wanted to share my previous blog post regarding tax-loss harvesting. The points discussed below will be relevant for 2022 1099-B Tax forms.
2020 Financial Markets in Review
During the volatile 2020 market cycle, the major market indices ended the year with strong gains. The Dow Jones Industrial Average, S&P 500 and Nasdaq increased 7.3%, 16.3% and 43.6%, respectively. With these strong returns, most investors were expecting to have tax liabilities due to realized capitals gains. But should they?
Review Your 1099-B for Realized Gains
A 1099-B tax form lists the realized gains/losses from broker transactions which an investor is required to report to the IRS. While most people simply forward this form to their tax advisor, I suggest you review this form to evaluate your investment manager. If you discover "net realized gains" and/or no "net realized losses" for 2020, that could be a warning sign that you may not have a tax conscious financial advisor. An advisor who is managing assets for tax efficiency likely would have been able to offset taxable gains in most diversified portfolios by implementing a strategy called "tax loss harvesting."
What is Tax Loss Harvesting
While losses are never the goal, losing money in an investment can sometimes have an upside. With a tax-loss harvesting strategy, investment losses in one or more investments can be used to help offset gains in others, which may result in a lower overall tax liability. In addition to offsetting capital gains, investors can "realize" losses to offset ordinary income, up to $3,000 in a single year for joint filers ($1,500 for single filers), according to the IRS. Investors may carry forward any losses indefinitely to offset future gains. Figure 1 provides a hypothetical example of how this strategy works.
Assumes a 35% combined federal/state marginal income tax bracket. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product and the example does not reflect the effects of fees. 2
Why 2020 was a Great Tax Loss Harvesting Year
Between Feb 20 and March 23 of last year, the equity markets dropped over 30 percent. The credit markets including high yield bonds and tax free municipal bonds also experienced severe, double digit corrections.
While the severe drops in valuations were painful for investors, there was a silver lining because of the opportunity that was presented to "realize losses" and offset "realized gains". Because of the breadth and depth of the correction, there were many assets that could have been sold for losses and swapped into similar strategies to maintain risk exposure.
While every investor has a unique portfolio, the amount of losses that could have been realized in many cases may have been enough to not only offset realized gains, but also be booked and carried over to future years. Having carryover losses "in the bank" can provide significant tax savings which means more money invested for compounded investment growth.
When using a tax-loss harvesting strategy, it's important to keep a few things in mind:
Be mindful of the IRS's wash sale rule:
This rule prohibits the purchase of the same or "substantially identical" security within 30 days (before or after) of selling that security at a loss. You also may not sell a security at a loss in a taxable account and purchase the same security for a tax-deferred account within 30 days of the sale. However, you may purchase a similar investment to maintain exposure to that industry or sector.
Know your alternatives
Consider the relative advantages and disadvantages of using ETFs, active mutual funds or indexed mutual funds to replace a security at a loss.
Don't let taxes alone drive the sell decision
Before harvesting losses, make sure the sale makes sense for your overall strategy and goals. If your goal is to exchange into a similar security and you are unable to find something similar, then maybe a sale does not make sense.
This strategy works for taxable accounts only
There's no benefit to harvesting losses in a tax-deferred account like an IRA, Roth IRA or 401k.
Losses can't be used after death
A tax loss can be used anytime over the lifetime of the account holder, but not beyond. But there is an important wrinkle in the tax law that married couples should keep in mind. During the final year that a couple files jointly after one spouse dies, the losses from one spouse’s brokerage account can be used to offset gains by the other spouse.
The best financial plans can be derailed by unsophisticated investment portfolio management. While many investors understand that taxes affect investment returns, they oftentimes are not aware of how much they are overpaying in taxes by not implementing tax advantaged strategies. Investors should use tax loss harvesting to:
1: Offset any realized capital gains on an annual basis.
2: Declare the maximum allowable capital loss annually ($1,500 individual, $3,000 joint filers).
3: "Bank" losses that can be used to offset gains in future years.
Management of gains and timely realization of losses across different market cycles can help to materially improve long-term after-tax performance. Higher taxes, like those being proposed by Congress, will make thoughtful tax management even more critical in the years ahead.
Please schedule a call with me if you would like to discuss tax efficient investment strategies in more detail.
- Source: Schwab Center for Financial Research