When it comes to investing, the advice “buy low, sell high” is often cited, and for good reason. It’s a timeless principle. However, there are instances where selling at a loss can actually work in your favor. This may sound counterproductive, but in certain situations, selling low can provide valuable financial benefits.
This strategy is known as tax-loss harvesting, and it’s a tool that many investors overlook. Used effectively, it can reduce your tax liabilities and improve your overall investment returns. Let’s explore how tax-loss harvesting works, its advantages, and how direct indexing can take your tax strategy to new heights.
Understanding Tax-Loss Harvesting
Tax-loss harvesting is a strategy that involves selling investments that have lost value to realize a capital loss. This loss can then be used to offset gains from other investments, lowering the amount of taxes you owe. If your losses surpass your gains, you can apply up to $3,000 of the excess loss to offset ordinary income each year, with any remaining loss carried forward to offset future gains.
How Tax-Loss Harvesting Works
To implement tax-loss harvesting, here’s a step-by-step guide:
- Identify Losses: Review your investment portfolio to pinpoint securities that have dropped in value and can be sold at a loss.
- Sell the Investments: Sell these securities to lock in the capital loss.
- Offset Gains: Use the realized losses to offset gains from other investments. Short-term losses first offset short-term gains, while long-term losses offset long-term gains.
- Reinvest Proceeds: Reinvest the proceeds from the sale into similar securities that aren’t “substantially identical,” avoiding the wash-sale rule. Ideally, choose investments that track similarly to maintain your investment strategy.
- Carry Forward Excess Losses: If your losses exceed your gains, you can offset up to $3,000 of ordinary income and carry forward any remaining losses to future years.
Why Tax-Loss Harvesting Can Benefit You
- Lower Your Taxable Income: By offsetting capital gains with losses, you can reduce your taxable income, potentially decreasing your overall tax bill.
- Boost After-Tax Returns: Reducing your tax obligations allows you to keep more of your investment gains, improving your net returns.
- Strategic Portfolio Management: Tax-loss harvesting enables you to manage your investments more effectively by selling underperforming assets and reinvesting in more promising opportunities.
- Offset Ordinary Income: If you have more losses than gains, you can use up to $3,000 of those excess losses to offset your regular income, offering even more tax savings.
- Carry Forward Unused Losses: Any losses you don’t use this year can be carried forward to future years, providing tax relief down the line.
What is Direct Indexing?
Direct indexing is a strategy where instead of buying an index fund or ETF, you purchase the individual stocks that make up the index. For instance, if you want to mirror the S&P 500, you would buy the actual stocks that comprise that index, rather than investing in an S&P 500 ETF.
This approach becomes particularly useful when you need to harvest tax losses. If some stocks in your direct indexing portfolio decrease in value, you can sell those individual stocks to realize a loss, which can be used to offset gains from other investments. This method gives you flexibility to reinvest in similar stocks within the same sector or industry, all while maintaining your overall investment strategy.
Direct indexing is especially valuable for high-income individuals in higher tax brackets, as it offers more control and flexibility than traditional index fund investing.
How Direct Indexing Enhances Tax-Loss Harvesting
- More Opportunities for Loss Harvesting: Direct indexing gives you the ability to sell individual stocks that have declined in value, allowing for more precise tax-loss harvesting compared to an index fund or ETF, where you’re limited to the performance of the entire index.
- Customization: This strategy lets you personalize your portfolio to exclude certain stocks or sectors, align with your ethical values, or focus on specific investment themes. Additionally, you can reduce exposure to stocks you may already have too much of.
- Maximized Tax Efficiency: By harvesting losses on individual stocks, you can optimize your tax savings and increase your after-tax returns.
- Avoiding Wash Sales: Direct indexing makes it easier to avoid the wash-sale rule by allowing you to replace sold stocks with similar, but not identical, investments.
Conclusion
Tax-loss harvesting is a highly effective strategy for reducing your tax burden and improving after-tax returns by selling investments at a loss to offset gains. It allows you to strategically manage your portfolio, ensuring your money works harder for you. When combined with direct indexing, the potential benefits of tax-loss harvesting are amplified. Direct indexing provides greater flexibility, allows for more personalized investment strategies, and enhances tax efficiency.
If you’re looking to optimize your tax strategy and increase your investment returns, both tax-loss harvesting and direct indexing should be part of your toolkit. Many financial professionals, including myself, are increasingly incorporating these strategies for clients to help them reach their financial goals more efficiently.