26 Nov
Tax loss harvesting is a well-known strategy for minimizing tax liability by offsetting capital gains with capital losses. However, the strategy’s full economic impact and planning implications are often misunderstood. While it’s generally advised to defer recognizing gains as long as possible, the increasing capital gains tax rate has made loss harvesting more appealing in recent years. As tax rates change, such as the potential rise in capital gains taxes for 2024, the decision to harvest losses becomes a key consideration for tax planning.
What is Tax Loss Harvesting?
Tax loss harvesting allows investors to reduce their tax liability by selling investments at a loss to offset gains from other sales. The most common scenario occurs when an investor sells appreciated stocks but wants to avoid the resulting capital gains tax. To do so, they might sell enough securities that have declined in value to offset the gains. After waiting at least 31 days to avoid the wash-sale rule (which disallows claiming the loss if the same security is repurchased within 30 days), the investor can repurchase the same stocks, keeping their portfolio intact.
At first glance, this strategy seems straightforward—harvest losses to offset taxable gains, reducing the amount of tax owed with no real risk to the portfolio. However, while this is often recommended by advisors, a deeper look reveals that tax loss harvesting may not always be as beneficial as it seems.
Understanding the Tax Impact
To better grasp how loss harvesting works, let’s look at an example updated for the 2024 tax year.
Example: John’s Loss Harvesting Strategy in 2024
John recognizes $30,000 in long-term capital gains in 2024. He owns 1,500 shares of ABC Corporation stock, which he purchased for $150,000 in 2020. As of late 2024, the value of the stock has dropped to $120,000. John decides to sell all 1,500 shares, realizing a long-term capital loss of $30,000 ($150,000 – $120,000). This loss can offset his $30,000 capital gain for the year.
Immediate Tax Savings:
- John’s capital gains tax rate for long-term gains in 2024 is 15%.
- Tax savings from the $30,000 loss = $30,000 × 15% = $4,500.
So, John saves $4,500 in taxes for 2024 by harvesting the loss.
Reacquiring the Stock:
- After waiting at least 31 days to avoid triggering the wash-sale rule, John repurchases the same 1,500 shares at the same price of $120,000, establishing a new basis of $120,000 in the stock.
The stock’s value increases to $180,000 by 2026, and John decides to sell.
Tax Impact on Future Sale:
- Selling the stock in 2026 for $180,000 results in a capital gain of $60,000 ($180,000 – $120,000).
- Tax on the $60,000 gain at a 15% rate = $60,000 × 15% = $9,000.
If John had not engaged in loss harvesting in 2024, he would have had a basis of $150,000 in the stock when he sold it in 2026, leading to only a $30,000 gain ($180,000 – $150,000). In that case, his tax liability would have been:
- Tax on the $30,000 gain = $30,000 × 15% = $4,500.
Comparing the Two Scenarios
- With loss harvesting: John pays $9,000 in taxes in 2026.
- Without loss harvesting: John pays $4,500 in taxes in 2026.
Difference in taxes paid = $9,000 (with harvesting) – $4,500 (without harvesting) = $4,500.
In this case, John saved $4,500 in 2024, but ultimately, he ends up paying an additional $4,500 in 2026. The result is a net tax-neutral outcome.
Enhancing the Effectiveness of Tax Loss Harvesting
Tax loss harvesting can be an effective strategy for managing tax liability, but the results are influenced by several factors. These variables play a significant role in determining whether tax loss harvesting will yield favorable outcomes in any given situation. Key considerations include:
- The tax rate on the income offset by the harvested losses
- The tax rate when the assets are eventually sold after being reacquired
- The taxpayer’s cost of capital (opportunity cost)
- The holding period before the reacquired assets are sold
Impact of the Tax Rate on Offset Income
The tax benefits from loss harvesting depend heavily on the type of income that the harvested losses offset. For example, losses can offset long-term capital gains, which are generally taxed at a lower rate (15% in 2024), or short-term capital gains, which are taxed at the taxpayer’s ordinary income rate. In cases where losses exceed gains, up to $3,000 of the excess can be used to offset ordinary income, reducing the overall tax burden.
Let’s explore how the timing and type of gains offset by losses can significantly increase the benefits of loss harvesting.
Example: Sarah’s Tax Loss Harvesting in 2024
Sarah has $40,000 in short-term capital gains for 2024, taxed at her ordinary income rate of 35%. She also has $40,000 in long-term capital losses. Sarah decides to use the losses to offset her short-term gains rather than long-term gains, leading to a much greater tax savings.
- Offsetting short-term capital gains:
The capital loss offsets the $40,000 short-term gain, which is taxed at 35%.
Tax savings from the short-term offset = $40,000 × 35% = $14,000.
In comparison, if the loss were used to offset long-term gains taxed at 15%, the tax savings would be:
- Offsetting long-term capital gains:
Tax savings from the long-term offset = $40,000 × 15% = $6,000.
By using the losses to offset short-term capital gains instead of long-term ones, Sarah achieves an additional $8,000 in tax savings.
Tax Rate on Reacquired Assets
Another important factor is the tax rate that applies when the reacquired assets are eventually sold. If the tax rate on long-term capital gains increases, it can diminish the benefits of loss harvesting. In 2024, the long-term capital gains tax rate is 15%, but it is expected to rise to 20% for higher earners in 2025. This increase would make harvesting losses less attractive, as the future tax impact would be higher due to the increased tax rate on the gains realized from the sale of reacquired assets.
Example: John’s Harvesting in 2024 with Future Higher Rates
John harvests losses in 2024 and sells the reacquired stock in 2026 when the capital gains rate is increased to 20%. Here’s how the tax consequences change:
Loss harvesting in 2024:
John saves $5,000 by using the $25,000 in losses to offset his capital gains at the 15% rate.Reacquired stock sale in 2026 at the higher rate:
John’s stock has appreciated, and he sells it for a $30,000 gain. At a 20% capital gains tax rate, the tax due on the $30,000 gain would be $6,000.
If John had not harvested the loss, his tax on the $30,000 gain would have been calculated as follows:
- Without loss harvesting:
Tax on the $30,000 gain at the 15% rate = $30,000 × 15% = $4,500.
Thus, while John saves $5,000 in 2024, he faces a $6,000 tax liability in 2026 due to the higher capital gains rate, resulting in an additional $1,500 in taxes.
Opportunity Cost of Capital
Another critical factor in evaluating the benefit of tax loss harvesting is the opportunity cost of capital—the potential returns on the money saved by harvesting losses. In some cases, if the taxpayer could invest the savings in a way that produces a return, the timing benefit could be even more substantial.
Let’s assume John uses the $5,000 saved from loss harvesting and invests it at an after-tax return of 5% per year. In two years, the $5,000 would grow to:
- Future value of tax savings after two years = $5,000 × (1 + 0.05)^2 = $5,512.50.
This growth in tax savings provides an additional benefit, making the timing advantage more significant.
Time Between Reacquisition and Sale
The longer the taxpayer holds the repurchased stock before selling, the greater the potential for the saved tax amount to grow. In previous examples, the taxpayer held the stock for only two years, resulting in a relatively small timing benefit. However, if the stock is held for a longer period, the timing advantage becomes more substantial.
Example: David’s Long-Term Holding and Tax Savings in 2024
David harvests a $20,000 loss in 2024 and saves $3,000 in taxes. He decides to hold the repurchased stock for 20 years. Assuming the tax savings grow at an annual rate of 5%, the total growth of the $3,000 saved is:
- Growth of $3,000 over 20 years at 5% annually = $3,000 × (1 + 0.05)^20 = $7,960.
At the time of selling the stock in 2044, David faces a $3,000 tax bill due to the initial loss harvesting. The net benefit from the timing advantage is:
- Total advantage = $7,960 (tax savings growth) – $3,000 (tax due) = $4,960.
Thus, by holding the stock for 20 years, David realizes a greater net benefit from tax deferral.
Stock Price Risk
One additional risk factor to consider is the potential fluctuation in the stock price during the 31-day period required for the wash-sale rule. If the stock’s price rises during that period, the investor will have to repurchase the stock at a higher price, reducing the benefit of loss harvesting. Conversely, if the stock price falls, the investor can repurchase it at a lower price, realizing further gains.
Example: Clara’s Experience with Price Fluctuations in 2024
Clara sells $50,000 worth of stock at a loss, and after waiting 31 days, she repurchases the stock. However, instead of the stock price staying the same, it increases from $80,000 to $81,000 during the wash-sale period. As a result, Clara buys back the stock at a higher price, meaning her basis increases to $81,000 instead of $80,000. This $1,000 increase in the repurchase price reduces her potential future gain.
If Clara sells the stock in the future for $100,000, her capital gain will now be $19,000 ($100,000 – $81,000) instead of $20,000 ($100,000 – $80,000). This $1,000 loss in future gain is compounded by the opportunity cost of not holding the stock during the 31-day period.
Clara’s final tax situation is:
- Net loss from price increase = $1,000 reduction in capital gain.
- Net result after factoring in her tax bracket: $542 (after accounting for capital gains tax).
This illustrates the risk that can come with being out of the market for a short period during the wash-sale rule.
Considering Gain Harvesting
In some situations, it may make sense for an investor to harvest gains rather than losses, especially if they can take advantage of a lower tax rate in the current year. For example, if the tax rate is expected to rise in the following year, harvesting gains now could help an investor pay taxes at the current, lower rate.
Example: Emily’s Gain Harvesting Decision in 2024
Emily owns 1,000 shares of DEF Corp with a cost basis of $1,000 per share, and the current market value is $1,100 per share. Emily faces the decision of whether to sell the stock in 2024 (paying a 15% capital gains tax) or wait until 2025, when the tax rate increases to 20%.
If she sells in 2024:
She realizes a gain of $100,000 ($1,100 – $1,000) and pays 15% in taxes:
Tax = $100,000 × 15% = $15,000.If she waits until 2025:
The same $100,000 gain is taxed at 20% in 2025:
Tax = $100,000 × 20% = $20,000.
Emily’s decision ultimately depends on her ability to invest the $15,000 saved by paying taxes earlier. If she can invest that $15,000 at an after-tax return of 5% per year, the amount would grow as follows:
- Future value of $15,000 invested at 5% for one year = $15,000 × (1 + 0.05) = $15,750.
In this case, if Emily expects her investment to grow more than the $5,000 saved by waiting for the higher tax rate, she should harvest the gain now.
Opportunity Cost Threshold
The after-tax opportunity cost of capital necessary to make deferring the tax payment worthwhile can be calculated. For Emily, if her investment grows at more than 33.33% in one year, it would be better to defer the tax payment until 2025.
- 33.33% growth on $15,000 = $15,000 × (1 + 0.3333) = $20,000.
If her investment grows at this rate or more, deferring the tax to 2025 would be the better choice. However, in most cases, Emily would likely benefit from harvesting the gain in 2024, paying the lower tax rate now.
Conclusion
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