What is Tax-Loss Harvesting and Why is it Important?

December 6, 2024

December 4, 2024

By

Conway Wealth

Tax-loss harvesting is an effective investment strategy for individuals seeking to optimize their portfolios, minimize tax burdens and maximize long-term wealth. By strategically selling underperforming investments, investors can offset taxable gains and retain more of their earnings.

For families navigating the complexities of significant financial portfolios – especially those approaching retirement – tax-loss harvesting can play a critical role in preserving wealth. This guide provides a deep dive into what tax-loss harvesting entails, why it’s particularly important for high-net-worth investors and how to implement this strategy effectively.

Quick facts

  • Tax-loss harvesting offsets taxable investment gains by selling underperforming assets.
  • It can reduce your tax liability and boost long-term portfolio returns.
  • Studies show tax-loss harvesting can increase returns by an average of 0.85%-1.10% annually.1
  • Best suited for high-net-worth investors looking to manage tax burdens and optimize wealth in retirement.
  • It’s important to note that tax-loss harvesting is not a relevant strategy for assets held in tax-advantaged accounts such as individual retirement accounts.

What is tax-loss harvesting?

Tax-loss harvesting is a tax strategy used by investors to manage capital gains and losses effectively. At its core, it involves selling investments that have lost value to offset taxable gains from other profitable investments.

How it works

The strategy operates on a simple principle: The IRS allows taxpayers to offset capital gains with capital losses. If losses exceed gains, up to $3,000 of the remaining loss can be deducted from other income (such as wages or interest). Any excess losses can be carried forward to future tax years, extending the benefits over time.2

And, fortunately, the market provides ample opportunity to utilize this strategy. Between 2007 and 2022 there were 1,394 stocks that were negative each year in the Russell 3000 index and 1,696 that were positive.3

The wash-sale rule

One critical element to keep in mind is the IRS's wash-sale rule. This regulation prevents investors from claiming a tax deduction if they repurchase the same or a "substantially identical" security within 30 days of the sale. For example, if you sell shares of a stock at a loss and repurchase them the following week, the IRS disallows the tax benefit.

By adhering to the wash-sale rule, investors can execute tax-loss harvesting effectively while staying compliant with regulations.

Importance of tax-loss harvesting for high-net-worth investors

High-net-worth investors often face unique financial challenges, including higher tax liabilities, diversified portfolios and the need for efficient wealth preservation strategies. Tax-loss harvesting addresses these concerns by providing several key benefits:

Reduced tax liabilities

For investors in high tax brackets, even a modest reduction in taxable income can translate into substantial savings. Tax-loss harvesting minimizes the amount owed to the IRS, freeing up more capital to reinvest, cover living expenses or preserve for heirs. Over time, this strategy helps manage the tax drag on a portfolio, ensuring more resources are retained and compounded.

Portfolio efficiency and stability

Market volatility is inevitable, and underperforming assets are a natural part of any portfolio. Tax-loss harvesting not only offsets taxable gains but also allows investors to rebalance their holdings with minimal tax consequences. This ensures the portfolio remains aligned with the investor’s financial goals and risk tolerance – critical factors for those nearing or in retirement. A well-balanced portfolio provides stability during uncertain economic periods, offering peace of mind and greater financial security.

Enhanced long-term returns

While tax-loss harvesting doesn’t directly generate returns, its impact on reducing taxes allows investors to reinvest the savings. Over the years, the compounding effect of reinvested capital can lead to significant growth. This can translate into meaningful wealth accumulation, especially for high-net-worth individuals with substantial portfolios.

Planning for a secure financial future

For high-net-worth investors approaching retirement, tax-loss harvesting is more than a short-term tax strategy; it’s a tool for long-term financial planning. By lowering annual tax burdens, investors can preserve more of their wealth to meet retirement needs, fund healthcare expenses or support philanthropic goals. Additionally, this strategy ensures that portfolios remain optimized to withstand market fluctuations, providing a consistent income stream without depleting assets prematurely.

When combined with other financial strategies – such as estate planning, charitable giving and tax-advantaged retirement accounts – tax-loss harvesting helps create a comprehensive plan for maintaining financial security in later years.

Examples and case studies of tax-loss harvesting

Let’s bring this concept to life with an example:

A high-net-worth investor has a portfolio worth $5 million with a mix of stocks, bonds and mutual funds. Over the year, they experienced a $100,000 gain from selling shares of a profitable technology stock. However, their portfolio also included an underperforming energy sector ETF that lost $75,000 in value.

By harvesting the $75,000 loss, the investor reduced their taxable gain to $25,000. Assuming a 30% tax rate, they saved $22,500 in taxes. This savings could be reinvested into assets with higher-performing potential, further compounding their wealth over time.

Real world data backs this up, too. According to an MIT study, the average annual tax alpha from tax-loss harvesting ranged from 0.85% to 1.1% between 1926 and 2018. This indicates that tax-loss harvesting consistently added measurable value to investment portfolios across nearly a century, including during periods of significant market volatility.4

By leveraging these gains, investors could not only mitigate tax burdens but also compound higher net returns over time, making tax-loss harvesting a crucial element of long-term wealth optimization strategies.

Broader implications

The benefits of tax-loss harvesting go beyond immediate savings. It allows investors to rebalance portfolios without the fear of triggering high tax liabilities. For example, if a retiree needs to shift their portfolio allocation to safer, income-generating investments, tax-loss harvesting can help mitigate the tax impact of selling growth stocks.

Best practices for implementing tax-loss harvesting

To reap the full benefits of tax-loss harvesting, high-net-worth investors should approach the process with care and strategy. Here are best practices to consider:

Regular portfolio monitoring

Frequent portfolio reviews can help identify opportunities for tax-loss harvesting. Markets fluctuate constantly and identifying underperforming assets in real – time ensures you can capitalize on potential losses.

Timing is key

While tax-loss harvesting is often executed toward the end of the tax year, it can be beneficial during periods of market volatility or after significant portfolio changes. Proactively harvesting losses throughout the year can help smooth out tax obligations.

Navigate the wash-sale rule

To avoid violating the IRS's wash-sale rule, ensure you wait at least 30 days before repurchasing the same or a similar asset. Alternatively, consider investing in a comparable security that maintains your portfolio's exposure without breaching the rule.

Leverage technology and advisors

High-net-worth investors often have access to sophisticated tools like tax-optimized investment platforms or robo-advisors designed for tax efficiency. Additionally, working with a seasoned financial advisor can ensure that tax-loss harvesting aligns with broader financial goals.

Integrate tax-loss harvesting into a broader plan

This strategy works best as part of a comprehensive wealth management approach. Combine it with other techniques like charitable giving, estate planning or retirement account contributions to maximize its effectiveness.

Additional considerations for high-net-worth investors

While tax-loss harvesting offers significant advantages, it’s important to remain mindful of its limitations and potential drawbacks:

  • Short-term vs. long-term gains: Tax-loss harvesting works best for offsetting gains of the same type. Short-term gains are taxed at higher rates than long-term gains, so prioritize offsetting those first.
  • Transaction costs: Frequent trades can incur additional fees, potentially reducing the strategy’s overall benefit.
  • Emotional decision-making: It can be tempting to sell underperforming assets impulsively. Work with advisors to ensure decisions align with long-term objectives.

Bottom line

Tax-loss harvesting is a strategic and essential component of wealth management for high-net-worth investors. It allows you to minimize tax liabilities, optimize portfolio returns, and achieve long-term financial goals.

If you’re nearing retirement and looking to simplify your finances, a comprehensive strategy incorporating tax-loss harvesting could secure a more stable financial future. Working with qualified financial advisors can help tailor this approach to your unique needs and ensure compliance with tax regulations.

For more information on finding the right financial advisor that can address your unique needs, feel free to reach out directly to the Conway Wealth team by emailing info@conwaywealthgroup.com or calling 973.285.3640.

  1. MIT. “An Empirical Evaluation of Tax-loss – Harvesting Alpha.”
  2. IRS. “Topic no. 409, Capital gains and losses.”
  3. Data from FactSet
  4. MIT. “An Empirical Evaluation of Tax-loss – Harvesting Alpha.” Past performance is not a guarantee of future results.

Investment advisory and financial planning services offered through Summit Financial, LLC, an SEC Registered Investment Adviser, doing business as Conway Wealth Group (4 Campus Drive, Parsippany NJ 07054. Tel. 973-285-3600). 7397313.1

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Initial 2021 Tax Considerations

With the swearing-in of a new President and Vice President, plus convening of the next Congress, affluent Americans are weighing how changes in federal government may financially impact them.

Given that Democrats hold the Presidency and control both Houses of Congress by a slim margin, it now seems likely that tax reform could be passed as a budget reconciliation bill and then signed into law. While there is a remote chance that expected tax changes will be retroactive, it is more probable that they would take effect immediately upon becoming law or even at the start of 2022.

Since 2021 may be a last opportunity to capitalize on current income, capital gains, and transfer tax laws, families are considering key financial & estate planning adjustments, where appropriate.

Income & Capital Gains Tax Proposals

With the swearing-in of a new President and Vice President, plus convening of the next Congress, affluent Americans are weighing how changes in federal government may financially impact them.

Given that Democrats hold the Presidency and control both Houses of Congress by a slim margin, it now seems likely that tax reform could be passed as a budget reconciliation bill and then signed into law. While there is a remote chance that expected tax changes will be retroactive, it is more probable that they would take effect immediately upon becoming law or even at the start of 2022.

Since 2021 may be a last opportunity to capitalize on current income, capital gains, and transfer tax laws, families are considering key financial & estate planning adjustments, where appropriate.

“Be fearful when others are greedy and greedy when others are fearful.”

Responsive Planning

Given the above proposals, there is great uncertainty surrounding future tax policy. Even if some of the more benign tax provisions now in effect are not repealed, many of them are scheduled to sunset at the end of 2025 already.

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  • Phase out the 20% pass-through deduction on qualified business income for people with annual income exceeding $400,000
  • Eliminate capital gain deferral through like-kind exchanges of business & investment real estate for people whose yearly income exceeds $400,000
  • Increase the highest corporate income tax rate from 21% to 28% and subject corporate book income of $100,000,000 or more to a 15% alternative minimum tax
  • Double the tax rate on global intangible low tax income (GILTI) earned by foreign subsidiaries of American businesses from 10.5% to 21%
  • Impose a 10% surtax for U.S. companies that move manufacturing & service jobs to another country and then provide services or products for sale back to the American market
  • Create an advanceable 10% “Made in America” credit for manufacturers’ revitalizing, re-tooling and hiring costs
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