Tax Day Countdown: 6 Common Mistakes To Avoid When Harvesting Year-End Tax Losses
Written by
John Csiszar
Edited by
Rebekah Evans
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For many investors, tax-loss selling is a year-end ritual and can vary depending on your long-term capital gains or losses. But not everyone is familiar with this tax-saving strategy.
Essentially, harvesting tax losses involves realizing capital losses by selling losing positions. These losses are then used to offset any capital gains (which are taxable) investors may have taken earlier in the year.
Up to $3,000 in excess losses can even be used to reduce ordinary taxable income, and even greater losses can be carried forward to be used in future tax years to serve more fruitful tax purposes. Overall, the purpose behind harvesting losses is to reduce taxes, which improves the after-tax return of an investor.
However, there are caveats to this strategy that can diminish its effectiveness for your tax bill. Especially when you try to get long-term capital gains or short-term capital gains to offset short-term losses or long-term losses.
Here are the things you’ll want to watch out for according to tax professionals.
Falling Prey To Wash Sale Rules
The wash sale rule prohibits investors from taking a loss on a security and replacing it with a “substantially identical” security in the 30 days before or after the sale, according to Fidelity. If you violate this rule, the IRS will disallow your investment loss.
Without this rule, investors could simply sell a losing security and immediately buy it back, capturing the tax loss but still maintaining the original position or better long-term gains.
While the calendar restrictions are fairly easy to observe, it can be trickier to avoid the “substantially identical” prohibition. If you sell a stock in one industry and replace it with a mutual fund or ETF, for example, you’ll generally satisfy the rule.
If you sell one steel stock and replace it with another, the IRS might question your trade. It’s usually best to consult a tax expert if you tread in this type of gray area.
Sacrificing Opportunity for Tax Benefits
Although selling a stock at a loss can save on your taxes, you’re giving up the opportunity to generate gains on that asset for at least 30 days. This is why many experts recommend that you never sell a stock on a cost basis for tax reasons.
It would defeat the purpose of the whole strategy if, for example, you save $500 in taxes but miss out on a $1,000 gain. If you’re looking to harvest tax losses, it’s usually best to stick to assets that you were considering unloading to begin with rather than simply selling all of your losing positions.
Overlooking Trading Expenses
In the era of zero-commission trading, the expense of taking tax losses has been greatly diminished. However, if you still pay commissions or fees to trade — or if you have other fees attached to your individual transactions — you’ll have to factor these in when determining if a tax-loss sale makes sense.
If you save $300 in taxes taking a tax loss but it costs you $300 to make that trade, then your benefit evaporates.
Only Harvesting Losses at the End of the Year
Although harvesting losses is a common practice at the end of the year, you can use this strategy at any time that it makes sense. Historically speaking, markets have two of their best months of the year in November and December, a time when many investors and even portfolio managers are harvesting losses.
It may make sense to harvest a loss when it is large, perhaps in a less-robust month, rather than selling it after its losses have diminished, according to the experts at Frontier Asset Management.
Not Considering Your Entire Portfolio
Stocks are the most commonly used instrument for tax-loss harvesting, but you can take a loss on any capital asset and use it to reduce your taxable gains. Mutual funds, exchange-traded funds, bonds, precious metals, artwork, collectibles or other non-stock assets can all be used for tax-loss harvesting purposes.
Upsetting Your Target Portfolio Allocation
If you’re selling assets to harvest tax losses, be sure that it doesn’t knock your desired asset allocation out of whack. This is particularly true if you’re making sales across different asset classes.
For example, if you’re harvesting losses from both bonds and stocks, be sure to invest the proceeds in new positions that maintain your original portfolio balance.
If you’re holding cash to avoid the 30-day wash sale rule, understand that you’ll be over-invested in cash relative to your original asset allocation for a full month, a position that’s typically undesirable for investors, according to Frontier Asset Management.
Caitlyn Moorhead contributed to the reporting for this article.
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