Using market volatility to lower a client tax bill
Using market volatility to lower a client tax bill means selling positions that have fallen in value to realize losses. Those losses can then offset realized gains, a practice known as tax-loss harvesting. In practice, the aim is to stay invested so a portfolio can participate in any recovery. However, results depend on each client’s tax situation, and the strategy does not guarantee a lower tax bill.
Using market volatility to lower a client tax bill: the formula
In accounting terms, the goal is a net loss in this calculation.
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, realized losses can offset gains realized during the same year. As a result, the tax owed on those gains may shrink or disappear. Those gains may come from sales or, for example, mutual fund distributions.
If losses exceed gains, a taxpayer may deduct up to $3,000 of net capital loss per year against ordinary income. The limit is $1,500 for married taxpayers filing separately (IRS Tax Topic 409). In addition, the limit applies per tax return, not per portfolio.
How carryover losses work
If net losses exceed the annual limit, the unused amount generally carries forward. They can offset future gains and, within the annual limit, ordinary income. In contrast, tax on net realized gains is generally due for that same tax year.
Here is a hypothetical illustration. Suppose an investor realizes $10,000 of gains and harvests $18,000 of losses in one year. First, the losses erase the $10,000 gain. Next, $3,000 may offset ordinary income. Finally, the remaining $5,000 may carry forward. Results vary by filing status.
When to look for harvesting opportunities
Volatile markets can push some positions below their purchase price, even in a year when the overall portfolio gains. Therefore, many advisers review client accounts for losses throughout the year rather than waiting for December. A sharp decline in one sector, for instance, may create a loss worth harvesting while other holdings stay profitable.
Meanwhile, the character of each loss matters. Short-term losses generally offset short-term gains first, and long-term losses generally offset long-term gains first. Short-term gains typically face higher tax rates than long-term gains. As a result, harvesting short-term losses can carry extra value for some clients. Of course, the adviser should also weigh the client’s income, filing status, and expected future gains before acting.
What the strategy must not do
Using market volatility to lower a client tax bill should not damage the portfolio. Instead, the portfolio should stay aligned with its investment objectives. For instance, harvesting often defers taxes rather than eliminating them, because the replacement position starts with a lower cost basis. Trading costs and tracking differences can also reduce the benefit.
Most importantly, advisers should coordinate this strategy with the client’s accountant and any other investment advisers. This article is general education, not tax, legal, or investment advice.
Where the wash sale rule fits
Above all, advisers must consider the wash sale rule before making portfolio changes. A wash sale generally occurs when an investor sells a security at a loss. The rule applies if the investor buys a substantially identical security within 30 days before or after. An IRA or spouse’s purchase can also trigger it. As a result, the investor cannot claim the loss that year.
For example, an adviser could hypothetically sell a fund tracking the S&P 500. The adviser could then buy a fund tracking the Dow Jones Industrial Average. The indexes often move similarly, but the Dow holds only 30 stocks, so returns can diverge. However, the IRS has not precisely defined “substantially identical,” so any swap carries risk. Therefore, advisers should confirm any swap with a tax professional.
