How tax harvesting turns market losses into tax savings

Activest uses a tax harvesting strategy that seeks to reduce clients’ tax burden when market volatility creates portfolio losses. This article explains how tax harvesting turns market losses into tax savings. Our goal is to stay invested so portfolios can participate in a possible recovery. However, results depend on each client’s tax situation, and the strategy cannot guarantee savings.

The arithmetic behind the strategy

In accounting terms, the goal is for the following formula to produce a net loss:

Net gain or net loss = (long-term capital gains minus long-term capital losses) + (short-term capital gains minus short-term capital losses)

In other words, the firm sells positions at a loss to offset gains realized during the year. As a result, the client may owe less tax on those gains, whether from sales or fund distributions. Keep in mind that harvesting generally defers taxes rather than eliminating them. The replacement position usually carries a lower cost basis, which can mean a larger taxable gain later.

In addition, net capital losses can offset up to $3,000 of ordinary income per year. The limit is $1,500 for married taxpayers filing separately, per IRS Topic No. 409. These limits may change, so confirm current figures with a tax professional.

What happens when losses exceed gains

Unused losses can carry forward to future tax years. For example, suppose a hypothetical investor realizes $20,000 of losses and $12,000 of gains. Next, up to $3,000 of the $8,000 net loss may offset ordinary income that year. The remaining $5,000 can carry forward to offset gains or income in later years. In contrast, tax on net realized gains is generally due for the year they occur. This illustration is hypothetical and reflects no actual client.

When harvesting may make sense

Harvesting tends to be most relevant during market declines, when some holdings trade below their purchase price. For example, a position bought near a market peak may show a loss months later. Its long-term outlook, however, may not have changed at all. In that case, the firm may sell the position and buy a similar investment to maintain market exposure. Meanwhile, the client remains invested and can still benefit if prices recover.

Timing also matters. In practice, investors can look for unrealized losses throughout the year rather than only in December. First, weigh the potential tax benefit against trading costs. Next, confirm that the trade still fits the account’s investment objectives. Finally, check whether a suitable replacement exists that is not substantially identical to the original. Of course, a loss that looks attractive today may shrink or disappear if the market rebounds before the trade occurs.

Rules that govern how tax harvesting turns market losses into tax savings

Taxes should not drive the portfolio. Instead, the firm aims to keep each account aligned with its specific investment objectives. Above all, clients should coordinate this strategy with their accountants and other advisers. Trade-offs include transaction costs and possible performance differences, and harvesting offers little benefit in IRAs and other tax-advantaged accounts.

Advisers must also consider IRS rules, most importantly the wash sale rule. It exists to discourage selling assets at a loss simply to claim a tax benefit. Buying a substantially identical security within 30 days before or after a loss sale triggers it. Consequently, the IRS disallows the loss for now and adds it to the new position’s cost basis.

For instance, an investor might sell a fund that tracks the S&P 500. Next, the investor could buy a Dow Jones Industrial Average fund, which often moves similarly but holds different stocks. However, the replacement may perform differently from the original. In addition, the IRS has not precisely defined “substantially identical.” Therefore, understanding how tax harvesting turns market losses into tax savings means reviewing each trade with a tax professional. This example is illustrative only and is not a recommendation to buy or sell any security.