Investors always want to improve after-tax returns, and tax-loss harvesting becomes their best friend in this pursuit. It is a widely discussed strategy among the investors, but is it truly worth the hype or just another tactic? To understand this, we need to evaluate the strategy from the lens of a financial planner or a financial advisor – through taxes, risk, and its long-term impact.
What is Tax Loss Harvesting?
In simple terms, tax loss harvesting means selling an investment at a loss and using that loss to offset capital gains. These losses can offset current year capital gains, up to $3000 of ordinary income, and future gains through carryforwards. The proceeds are then reinvested in a similar investment so that the investor’s portfolio stays aligned while experiencing the tax benefit.
Why do Financial Planners value tax loss harvesting?
Tax loss harvesting aims at tax deferral and is often viewed by financial planners as a long-term compounding tool. The objective is not to make profits out of losses but to defer taxes while keeping more of the investor’s capital invested at present. This amplified invested balance would compound and potentially provide higher after-tax returns over a period of time. This is one of the major reasons why many high-net-worth individuals work with financial advisors to make the most out of tax-loss harvesting in volatile years.
Who benefits the most from tax-loss harvesting?
A financial advisor would typically recommend tax loss harvesting for high-income individuals or investors expecting large capital gains and having long-term taxable accounts. Tax-loss harvesting is also recommended by financial planners to those with concentrated stock positions, as the compounding effect of tax deferral proves to be meaningful in such cases.
A seasoned financial planner would not recommend tax loss harvesting for every investor. Several factors, such as the investor’s tax bracket, trading costs, portfolio structure, and expected holding period, come into consideration. For instance, if an investor falls in a low tax bracket or if constant switching pushes them into undesirable investments, the strategy might deliver little to no benefit. Thus, the role of a financial advisor or a financial planner becomes crucial as they would help in ensuring that the investor does not harvest losses only for short-term tax reasons, while compromising with their long-term financial goals.
Avoiding the wash sale rule
The wash sale rule is one of the biggest pitfalls when it comes to tax-loss harvesting. If an investor sells a security and then buys a substantially identical or the same security within 30 days of the sale, the loss would be invalidated. A professional financial planner comes to the rescue in this scenario as they help the investor in choosing appropriate alternative investment instruments, maintaining the benefit of tax-loss harvesting, without violating the rule.
Tax loss harvesting is a smart strategy to amplify after-tax returns, reduce drag, and enhance long-term portfolio efficiency. It is a subtle contributor to overall wealth building, and its benefit can be quite powerful when executed aptly.
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