Losing money is no fun, I think we’d all agree on that. So unfortunately, we’re not having much fun in 2022! You know what else isn’t fun though? Paying taxes. To make sure you’re paying less taxes later, you should be tax loss harvesting now. Tax loss harvesting is the practice of selling a security at a loss, (to “harvest” the loss), which can then be used against future gains. We’ve written an explainer piece on tax loss harvesting in the past, so here we’re going to dive deeper using real world examples where the benefits of tax-loss harvesting will come into play.
The $3,000 deduction
Up to $3,000 of realized losses can be used as a deduction against ordinary income for the year. Any amount over $3,000 can be carried forward to the following year, or used against that year’s realized gains. This $3,000 limit is a small amount, but it still saves you money on taxes each year as shown below:
The savings are most impactful for those with lower incomes. A single person or a married couple making $100,000 or less will save more than 4% on their tax bill if they have $3,000 worth of realized losses to use against their income. These savings can be especially useful for retirees, who tend to see lower incomes in retirement than they had during their working years. Higher net worth individuals or couples probably won’t mind the extra $1,000 they can save too.
Any amount of losses beyond $3,000 can carry forward to the following year. For example, if you tax loss harvest $100,000 worth of losses in 2022, and use $3,000 to reduce your income, you’ll then have a $97,000 loss carry forward into 2023. You can then use the $3,000 deduction again in 2023 and be left with $94,000 to carry forward into 2024. A $100,000 tax loss can set up 33 years worth of $3,000 deductions. But be mindful that tax losses expire at death and do not pass on with an estate.
Big value: offsetting future gains
While there is a $3,000 limit on the deduction of losses against income, there is no such limit against future gains. For instance, a $100,000 loss in 2022 could be used to offset $100,000 of realized gains in the future. In theory, this means that an investor can realize capital gains from a taxable portfolio, totally tax-free. Let’s look at how this would work… An investor with a $1,000,000 portfolio realizes $100,000 worth of losses in 2022; (he sells his holdings in a Vanguard total market fund for a similar fund by Blackrock). Thus, their portfolio ends the year at $900,000.
Two years later, the investor’s portfolio has recovered to be worth $1,050,000. They now have an unrealized gain of $150,000. The investor decides they want to withdraw $50,000 to return the portfolio to its original value of $1,000,000. Doing so will trigger $7,143 worth of realized gains which we can calculate as follows:
This is where the value of tax-loss harvesting comes into play… remember the $100,000 worth of losses the investor took in 2022? That amount has been reduced to $94,000 after two years (he used the $3,000 deduction twice). But that’s still $94,000 worth of losses that can be used to offset realized gains.
So now, due to his withdrawal, the investor has $7,143 in realized gains in 2024 but $94,000 in unused losses left over from 2022. Because those losses from 2022 can offset his gains from 2024, he owes zero tax on the $7,143 in realized gains. This leaves him with $86,857 worth of unused losses ($94,000-$7,143=$86,857).
$3,000 of that $86,857 can again be used against ordinary income in 2024. Therefore, going into 2025, the investor will have $83,857 worth of losses remaining that will carry forward. Overall, he realized capital gains on his $1,000,000 investment totally tax-free.
How this can help with cash flow
As this previous example shows, tax loss harvesting can provide tremendous benefits when accounting for future cash flows. But let’s go back to this example and consider an alternative: doing nothing. In that case, the investor’s $1,000,000 still takes the same value path: it finishes 2022 worth $900,000 and then recovers to $1,050,000 by the end of 2024. But because the investor did nothing, he has no realized losses from 2022. However, he still wants to execute the same plan, and withdraw $50,000 from the account.
Doing so triggers a $2,380 realized gain, which will be taxed at long-term capital rates of 20% due to this investor’s income level. After accounting for $476 worth of taxes, the investor is left with $49,524. This is almost $500, or 1% less, than the investor who actively harvested tax-losses in 2022.
A 1% difference might not sound like a lot, but it can mean a lot of money when dealing with large portfolios. So for high net worth individuals who one day plan to make withdrawals from taxable accounts, tax-loss harvesting in 2022 can be extremely valuable down the road.
Furthermore, you never know when an emergency might arise that sees you dipping into your account. Now, imagine that emergency and then having to worry about the tax ramifications before you sell holdings in your portfolio to raise cash. If you’re not tax-loss harvesting you’ll have to be extra careful! If you are prudent with your tax loss harvesting, you’ll have less worry around taxes for your withdrawal. Taxes are the last thing you want to worry about during an emergency! One anecdotal example includes a client who withdrew money from their account to help a family member who recently lost their job.
Other use cases for tax loss harvesting
There are a number of other valuable use cases where tax loss harvesting will come in handy. Did you know that you can use stock market losses to offset capital gains from the sale of real estate? If you’ve lived in your home for a long time and expect to sell for a big profit within the next few years, tax loss harvesting in 2022 can lower your future tax bill. Or, consider the family who just bought a house in the last five years with no plans to sell for 10-20 years… well what do you think the value of your home will be worth then? Since losses can carry forward year after year, a large amount of tax losses in 2022 could still prove to be valuable 10 years from now.
Here’s another example we just dealt with this year: a client inherited securities that were not eligible for a stepped up cost basis. So the client ended up with hundreds of thousands dollars in low cost basis stock in a number of individual companies. In one instance, he had an unrealized gain of 10,000%! He wanted to reduce the concentration in these new inherited securities without triggering massive taxes.
Due to tax loss harvesting in his account earlier in the year, we were able to make substantial sales of the inherited securities without giving him a tax bill. We’d emphasize too that this inheritance was a surprise in the sense that the client thought he would be receiving a stepped-up cost basis. But since he didn’t receive the step up, the tax losses from earlier in the year played a crucial role in providing him flexibility around the sales.
Employees of public companies or start ups
Employees of public traded companies often receive equity compensation in their employer’s stock. Or, these employees may participate in their companies employee stock purchase program (ESPP). ESPP’s often let employees buy company stock at a 15% discount to the market price. If held for one year post purchase, the shares are eligible for capital gains treatment. At that time, any tax losses from other holdings can be used to offset gains from the ESPP.
This came in handy for a client of ours this year. He had a concentrated position in his company’s stock and wanted to reduce his exposure. He had held for a number of years and had unrealized gains in the $50,000 range. Due to tax loss selling in his other accounts, he was able to sell $25,000 worth of gains in his company stock without triggering any tax liability.
Private equity investors or business owners can reap the benefits of tax loss harvesting as well. In some cases, tax losses from the public market can be used to offset gains from privately held investments. This area of the tax code is more complicated though, so be sure to consult with a tax professional if it applies to you.
Recapping the benefits
To recap, here are the most obvious benefits of tax loss harvesting:
- $3,000 worth of losses can be used to reduce your income each year, saving you money on taxes owed.
- An unlimited amount of losses can be used to offset gains, in some cases allowing for gains in taxable accounts to earn tax-free treatment in a given year.
- Tax loss harvesting can be used against profits related to real estate, inheritance, employer stock, and some private equity.
At Blue Haven, we have been actively tax-loss harvesting on a consistent basis throughout all of 2022. The market has been down more than 10% at various points since February, and was down more than 20% at one point in June, so there’s been no shortage of opportunities to tax loss harvest.
While we love index funds, index funds don’t tax loss harvest for you! It’s up to you (or your advisor) to do it for you. In a year like this, when the value of your portfolio is probably down, it’s extremely important that you’re taking actions that will increase its value later. Tax loss harvesting in 2022 can do just that and it’s just one of the smart planning moves we’ve been making for our clients.
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