How to Improve Your Investment Returns Through Tax-Loss Harvesting

Selling a few underperforming holdings to save thousands in taxes may seem like a relatively easy choice, but there are many factors that should go into a decision to pursue tax-loss harvesting—tax efficiency is just one consideration among many. “Taxes should not be the first thing you think about when choosing what to buy and sell,” explains Roger Young, CFP®, a senior retirement insights manager with T. Rowe Price. “Don’t let tax reduction techniques derail your overall investment strategy.” As with any strategy, there are several key elements to keep in mind, including:

Focus on the fundamentals. Tax-loss harvesting is just one tool in service of your broader investment strategy. Investment fundamentals, such as remaining diversified and staying the course over the long term, are more important overall than short-term tax considerations. Ultimately, you want to make sure any tax-loss harvesting activities do not alter fundamental elements of your portfolio, such as your asset allocation and risk exposure. In addition, you don’t want to sell a position unless you can invest the proceeds in something with better expected returns.

Be alert for opportunities. Many investors assume tax-loss harvesting should take place in December, along with the rest of their year-end tax planning. This is also the time of year when investors typically receive information about dividend and gain distributions from their funds. However, tax-loss harvesting can be employed throughout the year. Of course, it can be difficult for individual investors to monitor their investments, and the potential tax consequences, throughout the year. If you can make time for this strategy, look for material losses—for example, 10% or more—to make tax-loss harvesting worth the effort and to avoid trading based on day-to-day volatility.

Consider losses across asset types. Tax-loss harvesting is not limited to individual stocks; if you have a taxable account that contains mutual funds or ETFs with losses, it’s worth considering a sale of those holdings as well. Just be careful when selling funds, as doing so can significantly alter your asset allocation. If you purchase another fund to keep your allocation aligned with your original allocation strategy, you must be careful not to invest in a fund that is “substantially identical” to the one you just sold; otherwise, you will run afoul of the IRS’s wash sale rule. (See “Understanding the Wash Sale Rule.”) Harvesting a loss in a fund could also create an opportunity to replace it with a more tax-efficient fund.

Cash can be a useful tool. Holding a cash position within a portfolio can be useful to take advantage of strategic opportunities. If an investor doesn’t want to liquidate a holding that has a loss, they could use their cash to increase their holdings temporarily and then consider selling to take losses (if still applicable) after 31 days to avoid the wash sale rule. (Remember that the market’s moves within those 31 days are unpredictable.)

Be tactical about account types. A portfolio that includes both taxable and tax-advantaged accounts (such as individual retirement accounts [IRAs]) can present additional opportunities for greater tax efficiency. “For example, you might be a little quicker to take profits in an IRA and to recognize losses in the taxable account,” says Mark Weigman, head of Private Asset Management at T. Rowe Price. “Having both account types adds some flexibility to the strategy.” The funds in a Traditional IRA aren’t taxed until the money is withdrawn in retirement, and any gains you realize in those accounts do not trigger a capital gains tax liability.

There are additional caveats beyond ensuring you keep your fundamental investment strategy intact. Complicated rules involving wash sales, loss carryovers, and short- versus long-term gains may affect results of the strategy. This is why T. Rowe Price recommends consulting with a tax advisor before pursuing a tax-loss harvesting strategy. Doing so is especially important if you consider purchasing a different investment in order to maintain an appropriate asset allocation. The tax advisor can help you understand the wash sale rule and avoid unpleasant surprises.

It’s also important to understand what to do if your losses outweigh your realized investment gains. Deductible net capital losses are limited to $3,000 per year ($1,500 if married filing separately), but excess losses can be carried forward to later years indefinitely.

Another consideration for investors is how to treat dividends and distributions in their taxable accounts. Dividend distributions often occur near the end of the year. Many investors have set up automatic dividend reinvestment and may forget that those shares acquired through dividend reinvestment may create wash sales. By having dividends and interest paid out in cash rather than reinvesting them, it is easier to avoid triggering the wash sale rules in a tax-loss harvesting strategy. However, this approach also requires diligence to ensure that cash is then invested in a manner that is aligned with your overall investment strategy. “You don’t want to build up too much cash in your portfolio, given its limited growth potential,” says Young.

Selling positions with losses requires judgment; it’s not something to do automatically, and it is not without risk. (See “A Portfolio Manager’s Perspective.”) While stocks or entire sectors can go out of favor, that doesn’t necessarily make them bad investments. Missing out on a recovery could potentially cost more in foregone gains than it saves in taxes. When executed successfully, however, a tax-loss harvesting strategy can help investors minimize their current capital gains taxes. For most people, delaying taxes is wise—and that is what a tax-loss harvesting strategy accomplishes.