A Way to Reduce Tax Bills in Down Markets

That scenario could pose an unexpected exposure for some investors, Ernst says. "It's very possible rebalancing trades took place around the time of that January market peak that realized long-forgotten capital gains, which might result in the investor paying capital gains taxes in a year when their portfolio is down sharply in value. Tax-loss harvesting trades now may be able to offset that unpleasant reminder when filing their 2022 tax return in April 2023."

For example, assume a client sold shares early in 2022 for a short-term gain of $10,000. In December 2022 she decides that one of her short-term holdings, which has lost $8,000 in value, has limited prospects for price recovery, so she sells it and takes the $8,000 loss. She can offset the loss against the $10,000 gain, resulting in a net short-term gain of $2,000.

Assuming she has a marginal income tax rate of 27% — 24% federal plus 3% state — the $10,000 gain would cost her $2,700 in taxes. But taking the $8,000 loss and reporting a net $2,000 gain ($10,000 less $8,000) generates just $540 in additional tax, reducing her tax bill by $2,160. She still takes an $8,000 portfolio loss, but the tax savings reduce the sting somewhat.

Even if she doesn't have any profitable trades for the year, she could still sell the losing position and apply $3,000 of the loss to reduce her 2022 income. The remaining loss balance would carry over to future years for use against realized gains or ordinary income.

A Few Caveats

The financial media often portray tax-loss harvesting as a straightforward way to lower tax liability, but it's not always that simple, Ernst cautions. Some key points to keep in mind when reviewing clients' portfolios for possible trades:

• Tax-loss harvesting works only with taxable accounts, not retirement accounts like IRAs or 401(k)s.
• Short-term gains are taxed as ordinary income, at rates up to 37%, plus the possible addition of net investment income tax and state income tax. Long-term capital gains' tax rates are lower, at 0%, 15% and 20%. "Tax-loss harvesting may not significantly benefit anyone who is already in the 0% capital gains bracket," Ernst says. "For instance, for a married filing jointly couple with taxable income significantly below $80,000, their applicable capital gains tax rate is already 0%."
• Short-term losses are first applied to short-term gains; long-term losses are first applied to long-term gains. If the investor has excess losses in a category, the excess can be used with the other category.
• Selling at a loss and then buying the same security or a "substantially identical" security within 30 days creates a wash sale, which will cause the loss to be disallowed.

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Ed McCarthy is a freelance financial writer who holds the certified financial planner and retirement income certified professional designations.