How can investors utilize tax losses?

Investors who have lost value since initial investment may want to consider selling so they may be able to utilize tax-loss harvesting.

What is tax-loss harvesting?

This is the strategy of going through taxable accounts and selling losing investments for the potential tax benefit. In short: It’s a way to keep more money.

When selling the losing stocks and other assets at a loss, investors might be able to use those losses to balance out the investments that made money.

How does tax-loss harvesting work?

Tax-loss harvesting is about selling stocks, mutual funds, exchange-traded funds (ETFs), or other securities that have lost value in an effort to reduce taxes on capital gains.

In other words, tax-loss harvesting may help investors reduce their income tax by using capital losses to offset capital gains. It may be better suited for long-term investors. The greatest benefit will be realized by investors in the higher income tax brackets.

In the hypothetical example below, the investor may save $2,250 by recognizing capital losses.

Tax without losses

Long-term capital gains
$20,000
Long-term gains tax rate

x15%


$3,000

Tax with losses

Long-term capital gains
$20,000
Long-term capital losses

($15,000)


Net
Net $5,000
Long-term gains tax rate

x15%


Tax

$750

In addition, if an investor’s losses exceeded the gains, the investor wouldn’t owe any capital gains tax and could:

Deduct up to $3,000 in excess losses from ordinary income per year

Carry over any remaining losses to future tax years

What’s the difference between short- and long-term gains?

Short-term gains come from assets held a year or less and are taxed as ordinary income.

Long-term gains come from assets held more than a year, with generally lower capital gains tax rates.

Here’s the kicker: The difference between these tax rates can be nearly 20%.

Short-term capital gains

  • Generated from investments owned one year or less
  • For 2019, taxed at investor’s ordinary income rate, up to 37%

Long-term capital gains

  • Generated from investments owned more than one year
  • For 2019, taxed at 15% for those with taxable income between $78,750 and $488,850 (married filing jointly) or $39,375 and $434,550 (single) and taxed at 20% for those with taxable income above those levels.

Why is the wash sale rule important?

When an investor sells an asset, they may decide to reinvest the proceeds, which can be complicated if they would like to buy a security that’s the same as (or substantially identical to) the one sold. That’s because the IRS’ wash sale rule disallows any tax benefit if the investor buys the same security or a substantially identical security within 30 days before or after the loss-generating sale.

What are some tax-loss harvesting dos and don’ts?

Do

  • Consider harvesting losses. This can offer benefits over a long period.
  • Consider holding off on loss harvesting if a portfolio won’t benefit for several years.
  • Be flexible. Be sure to consider the tax treatment of dividends and capital gains before deciding to harvest losses.

Don’t

  • Sell holdings without considering potential tax liabilities. Sometimes selling can trigger taxes you want to avoid.
  • Sell investments at a profit without considering whether there is an offsetting loss.
  • Select a manager, whether active or passive, without regard to potential tax implications.

Are there other strategies to help make portfolios more tax-efficient?

Tax-loss harvesting is just one of many strategies investors can use to help create a tax-efficient portfolio. Other strategies to consider include:

  • Investing in municipal or other tax-advantaged bonds
  • Investing in ETFs
  • Investing in SMAs (separately managed accounts) to control realization of gains and losses
  • Focusing on low-turnover strategies
  • Avoiding mutual funds with large impending distributions
  • Donating assets with large unrecognized gains to charity
  • Holding highly taxed assets in tax-favored accounts, such as IRAs

What are my key takeaways?

key takeaways icon

  1. First and foremost, an investment strategy should be based on financial goals, risk tolerance, and other factors.
  2. Investors who have sold investments and incurred capital gains may be able to offset those gains by selling assets that are valued at a loss.
  3. Consider using tax-advantaged accounts and tax-efficient vehicles (for example, municipal bonds and ETFs) along with tax-loss harvesting, which may help minimize an investor’s tax obligation.

Did we mention taxes are complicated?

icon for disclosures

The information in this report is general in nature and may not apply to your situation. Tax laws or regulations are subject to change at any time and can have a substantial impact on your individual situation. Wells Fargo and its affiliates are not legal or tax advisors. Please speak with your legal or tax advisor before making any decision that may have tax consequences.

A tax-loss harvesting strategy, as discussed here, can potentially provide investors with the opportunity to reduce their tax liability. This practice also bears certain risks including, among others, the risk that the new security will not perform as well as the original investment, transaction costs could offset any potential tax benefit, and there may be unintended tax implications.

There is no guarantee that any tax-managed strategy will be successful and meet its objective of being tax-efficient. An investment in a mutual fund or ETF* will fluctuate and shares, when sold, may be worth more or less than their original cost. All investing involves risk, including the possible loss of principal and fluctuations in the value of the securities held.

*ETFs continuously offer and sell shares through a daily in-kind purchase and sale process to “authorized participants” and not to investors. As a result, the ETF does not incur tax when securities are sold and the investor does not incur capital gains taxes until they sell their shares.

Examples used are for illustrative purposes only and does not take into consideration any commissions or fees. All investments are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors due to numerous factors some of which may be unpredictable. Be sure investors understand and are able to bear the associated market, liquidity, credit, yield fluctuation and other risks involved in an investment in a particular strategy.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

Wells Fargo Investment Institute is not a legal or tax advisor.

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