Tax-Loss Harvesting: What’s Popular Isn’t Always Right
As parents, we often ask our children if they would do something just because their friend did it. We do this to teach sound judgment and help them make better decisions in the future. Tax-loss harvesting (essentially, selling investments that lost value to offset capital gains) has gained popularity in the investment industry in recent years. Many investment firms make it sound like a no-brainer for their clients to implement, but that is really not the case. Yes, it can be a strategic investment approach to help offset capital gains and potentially reduce taxable income, but it's critical for investors to understand both the advantages and drawbacks. In this blog post, we'll explore the top three pros and cons of tax-loss harvesting.
Pros:
1. Tax Efficiency: One of the primary benefits of tax-loss harvesting is its ability to enhance tax efficiency. By strategically realizing losses, investors can offset capital gains, potentially minimizing their overall tax liability. This can result in savings over the long term, allowing clients to keep more of their investment gains.
2. Portfolio Optimization: Tax-loss harvesting provides an opportunity to rebalance and optimize investment portfolios. When properly implemented, it enables investors to sell underperforming assets and reinvest in potentially more promising opportunities (or on the flip side, selling low and buying high as noted under “Market Timing Challenges” below). This can be executed while still maintaining the desired asset allocation.
3. Risk Mitigation: Implementing tax-loss harvesting can serve as a risk management tool. In times of market volatility, realizing losses strategically can help to mitigate potential losses, providing a degree of downside protection.
Cons:
1. Wash Sale Rules: One significant drawback of tax-loss harvesting is the wash sale rule, which prohibits investors from repurchasing a "substantially identical" security within 30 days of selling it for a loss. Failing to adhere to these rules can result in disallowed losses. Navigating these restrictions requires careful planning to avoid unintended consequences, so you should probably consult with a fee-only investment advisor or tax accountant.
2. Market Timing Challenges: Tax-loss harvesting relies on selling investments at a loss, which can be challenging in a market where asset values fluctuate. Timing the market correctly is a complex task and may lead to missed opportunities or unintentional capital gains if not executed properly. Overemphasis on short-term tax considerations can compromise the long-term investment strategy.
3. Kicking The Can Down The Road: While tax-loss harvesting can reduce capital gains in the near term, you are essentially delaying when you pay the taxes, assuming the portfolio continues to grow. For example, if you sold Home Depot at a loss and bought Lowe’s and both stocks appreciated from that point on, you may offset some capital gains today, but eventually you pay taxes on the gains when you sell Lowe’s.
Tax-loss harvesting is not a one-sized fits all investment approach. It can be a valuable strategy to increase tax efficiency, but investors must navigate potential pitfalls and determine if it makes sense for them. As with any financial strategy, it's crucial for clients to work closely with a fee-only financial advisor to ensure that tax-loss harvesting aligns with their overall financial goals and risk tolerance.
Authored by Stephen Blahovec and Michael Rausch of North River Wealth Advisors. We are an independent, fee-only financial planning and investment management firm located in Pittsburgh, PA servicing clients locally and across the country. To learn more, contact us here.
This content is developed by North River Wealth Advisors from sources believed to be providing accurate information. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security.