The twists and turns of capital markets result in winners and losers within investment portfolios every year. For the winners, selling generates a capital gains tax and decreases your after-tax returns. However, as seen most recently in 2022, sometimes funds can also post sizable capital gains distributions in down years, adding insult to injury and further reducing your after-tax return in what was already a difficult year. These taxes result in permanent capital destruction and negatively impact your wealth. The silver lining? If you have taxable accounts in your portfolio, we at Aldrich Wealth work to offset taxable gains to help you keep more of what you earn. To accomplish this goal, our professionals proactively harvest losses to generate a “tax asset,” which can be used to increase after-tax performance. A tax asset does not expire, can be used to offset future tax liability, and, in some cases, eliminates taxes altogether, letting you keep more of your money so you can use it for the things that matter most to you.

Tax loss harvesting is a strategy used to reduce tax liability and increase after-tax return by strategically selling investments that have losses. By realizing losses, an investor can offset capital gains realized during the same or future tax years. The realized losses can be used to offset all or a portion of the realized gains that would ordinarily be taxable. If the total realized losses exceed capital gains, the excess losses can be used to offset up to $3,000 of ordinary income. If the losses are greater than the limit, the remaining losses can be carried forward to offset future gains and income in subsequent years.

The IRS has a “wash sale” rule that prevents investors from immediately repurchasing the same or a substantially identical investment within 30 days after the sale generated the loss. We manage this process for our clients as violating this rule disallows the loss for tax purposes. We track losses to ensure that clients do not lose a tax loss due to early repurchase.

If the investor isn’t interested in repurchasing the same or a substantially identical investment, the proceeds from the sale can be reinvested or utilized at the investor’s discretion. However, it is common for investors to either eventually repurchase the sold security or purchase a similar investment.

The following is an example of an investor who wants to ultimately maintain ownership but also wants to harvest the loss.

1. Purchased 1,000 shares of XYZ for $50 per share in 2020.
2. XYZ trading at $40 per share currently.
   • Sell 1,000 shares at $40 and realize a loss of $10 per share ($10,000 loss).
   • Repurchase 1,000 shares of XYZ 31 days after sale at $40 per share. Note, the actual purchase price is variable and could be higher or lower after 31 days.
   • Cost basis adjusted from $50 to $40 per share and $10,000 loss realized.
3. Sold ABC stock for a gain of $10,000 – estimated capital gains tax of 20% ($2000).
4. Gain of $10,000 offset by loss of $10,000 and no taxes due.
5. Still maintains ownership of 1,000 shares of XYZ.

In the above example, if the investor didn’t want to maintain ownership, the proceeds from the sale could be invested in another investment that maintains market exposure and may offer similar return potential. Switching between mutual funds or exchange traded funds is a common practice for remaining invested but not holding substantially identical investments.

An investor seeking to maximize after-tax value should consider tax loss harvesting. For taxable investors, the pre-tax return is what is typically presented in performance reports, but this may have little bearing on their ability to achieve their financial goals. It is the amount after taxes are paid the will ultimately drive spending capacity and wealth. Proactive tax loss harvesting will improve after-tax returns and support greater spending capacity than an approach that doesn’t take advantage of harvesting losses.

One of the biggest obstacles to loss harvesting is investors themselves. Investors don’t like hearing they have lost money and find it difficult to sell an investment at a price lower than they bought it. Loss aversion is a well-known behavioral bias that prevents many people from taking losses even though it makes financial sense. Taking a systematic approach to tax loss harvesting is key. Aldrich Wealth utilizes a process that focuses on maximizing after-tax return and set a process that removes the emotional elements of selling assets at a loss.

It is common for investors to begin tax loss harvesting near the end of the year. This is often because they have likely realized gains throughout the year and are facing taxes that will be triggered at the end of the year. However, if investments in general have risen in value, it may be difficult to find securities trading at a loss during the last month of the year.

We believe the best approach is to harvest losses throughout the year as financial markets are volatile and unpredictable and they may present loss harvesting opportunities at any point during the year. By having a strategy that is triggered by loss opportunity rather than the calendar, investors can take advantage of loss harvesting opportunities throughout the year. Even if losses are not fully utilized in the year they were realized, they can be used in future years to improve after-tax returns.

Tax loss harvesting is an effective tool for reducing or eliminating current tax liabilities. This is especially true if the replacement security offers similar return potential to the security that was sold. Mutual funds, exchange traded funds, and bonds are particularly good candidates as it is relatively easy to find replacement securities with similar risk and return expectations. Since the cost basis is reset to a lower level, gains on future sales could increase and this may reduce the benefit of loss harvesting. Tax loss harvesting is riskier if the investor wants to ultimately repurchase the sold security as the price could increase during the 30-day waiting period, forcing the investor to repurchase at a higher price than it was sold. If the price rises above the original purchase price, the investor may have been better off holding the security. However, if done consistently, tax loss harvesting should result in higher after-tax returns and less money going toward taxes.

Please note that tax and estate planning information offered by Aldrich Wealth is general in nature.  It is provided for informational purposes only and should not be construed as legal or tax advice. Tax advice and preparation is offered through Aldrich Advisors + CPAs.  Always consult an attorney or tax professional regarding your specific legal or tax situation.