Ask An Advisor: Consider Tax Loss Harvesting in Taxable Accounts

This strategy potentially turns your investment losses into tax breaks. If you invest in taxable accounts you are probably familiar with capital gains taxes. To “harvest“ losses you sell investments at a loss and then use those losses to offset realized investment gains in the same year. The key is to make a lateral move in your account and use the proceeds from the sale to purchase another similar investment or one that is similarly undervalued.

One of the most powerful benefits of tax-loss harvesting stems from the fact that after offsetting other capital gains, the first $3,000 ($1,500 if married filing separately) you accumulate in capital losses offsets ordinary income each year. Any remaining losses can be carried forward to future years. Since tax rates for ordinary income tend to be higher than long-term capital gains rates, your tax savings on the first $3,000 each year is equal to the difference between tax rates for long-term gains and ordinary income, multiplied by $3,000.

Let’s say that at the beginning of the year you invested $10,000 in an ETF or mutual fund that invests mostly in small U.S. companies and that fund is down 35% year to date. If you were to sell that fund you would recognize a $3,500 loss. You could then either offset the loss with up to $3,500 in gains or if you have no gains then take a $3,000 loss on your taxes and carryforward a $500 loss to use next year. You could then use the $6,500 in proceeds to purchase a similar fund or one that has had similar performance year to date. That way you can still potentially capture positive performance when the market rebounds.

I used this strategy for many of taxable client accounts during the recent market downturn and it is pretty impressive how it can substantially offset capital gains distributions and allow my clients to save large amounts on taxes (especially for those who are in the top tax brackets).

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Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Market Volatility: Investors should consider their financial ability to continue to purchase through periods of low price levels. A diversified portfolio does not assure a profit or protect against loss in a declining market.