Tax Loss Harvesting - When it doesn’t work
Tax loss harvesting = selling stocks or other securities at a tax loss with the intention to later use these losses to offset taxable gains. This strategy often includes repurchasing somewhat similar ‘replacement’ securities at a lower price. To the extent that capital losses exceed capital gains, the result can be deducted up to $3,000 per year with the remainder then carried forward into the next year.
Although lowering taxable gains in the future sounds like a no-brainer, tax loss harvesting may NOT work for every case. Why? Because when you sell at a loss and then repurchase a similar security, you’re ‘resetting’ your tax basis in the position at that lower amount meaning a LARGER gain on a sale in the future than you otherwise would have had. In other words, this strategy is typically DEFERRING taxable gain, not eliminating it.
Before knee-jerking tax loss harvesting, consider ways it might actually NOT benefit you. A few examples:
If you’re in a low federal tax bracket now, but could be in a higher tax bracket down the road. This could be due to changes in your tax situation, changes to tax law, or both. Tax loss harvesting NOW could actually cause you to pay higher federal income taxes on capital gains LATER.
Do you live in a state with no/low state income taxes now, but plan to move to a high/higher tax state later? You may end up paying state taxes on capital gains later that you might not otherwise have without tax loss harvesting.
For folks who are doing estate planning, know that your capital loss carryforwards die with you. Further, your heirs may receive a ‘step up’ in tax basis of inherited securities equal to their market value on your date of death. In other words, you may have generated unusable and unneeded tax losses at the expense of transaction costs on the sale.
What if you don’t have current or subsequent capital gains? Make sure you have gains elsewhere that could be offset.
Is tax loss harvesting a bad strategy? No, not at all! The point here is that this strategy should be used only if it makes sense with your unique tax profile and is in line with your long-term financial goals.