With only a few trading days left until 2023, tax loss harvesting can be a useful strategy to improve your after-tax investment results. Researchers suggest that this strategy can improve returns by about 1% each year. The paper is “An Empirical Assessment of Tax-Loss Harvesting Alpha” by MIT researcher Shomesh Chaudhuri and others, looking at returns from 1926 to 2018 for the S&P 500.
This approach may be applicable if you invest in stocks through a US taxable account. Tax loss harvesting can generate taxable losses without materially changing portfolio performance. This process can push the payment of capital gains taxes into the future. This delayed tax payment can improve your after-tax return on your investments because you can earn a return on that money over time instead of paying it to the IRS right away.
How tax loss harvesting works
If you invest in a taxable account, such as a regular brokerage account, you will likely realize capital gains and losses as you buy and sell investments over time. If you invest only in tax-sheltered or tax-deferred accounts such as 401(k)s, IRAs, and similar vehicles, then you are already deferring or eliminating tax on your investments, and tax loss harvesting is unlikely to do you any good.
Tax loss harvesting focuses on realizing taxable losses, especially short-term capital losses, to offset capital gains you might otherwise have to pay.
The way it works is you review your account for investments that you’ve held for less than a year and are worth less than you paid for them. These investments may qualify for short-term capital losses. You can then sell those shares to realize that capital loss, which can then offset capital gains elsewhere in your portfolio.
Importantly, wash sales can disqualify a trade from achieving a capital loss. Investments that you bought within the last 30 days or that you bought back 30 days after the sale can be treated as a wash sale. Wash sales can negate the benefits of tax loss harvesting because they can prevent a capital loss. Therefore, when you collect tax losses, if you sell an investment, you must buy something else with the proceeds. This could mean that if you sell shares in Coca-ColaKO that you are buying shares in Pepsi, for example, since buying back Coca-Cola shares within 30 days could trigger a failed sale.
Whether tax loss harvesting is beneficial to you also depends on your tax position. If you’re not about to pay income taxes anyway, tax loss harvesting may not provide any benefits. If you don’t pay taxes in the first place, then offsetting them with capital losses may not be beneficial.
Additionally, an individual taxpayer can offset as much capital gains as they wish, but absolute losses from a tax loss harvesting strategy cannot exceed $3,000 each year for an individual taxpayer.
Any tax loss carry forward for your 2023 taxes must be done before the end of the calendar year. This is different from some other tax strategies that have a later deadline. This means there are only a few trading days left in 2023 to consider implementing the strategy.
However, of course the strategy can also be applied in 2024, but it will apply to the tax year 2024. Now may be a good time to look for losing investments that you bought in 2023 and held for more than 30 days in a taxable account. If you sell them and replace them with a similar but not identical investment, this can offset some of the capital gains payment on your tax bill.
Alternatively, it can create an investment loss of up to $3,000 to offset income tax payments. This process of directing your capital gains tax payments further into the future can improve your overall investment results.
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