Tax Loss Harvesting: What You Need To Know

There may be a bright side to some of your recent portfolio declines. The recent surge in market volatility has created opportunities for tax loss harvesting, which is the practice of selling investments that have lost value to offset a portfolio’s current capital gains.

Harvesting losses has the potential to lower your tax bill, both in current and future years. Here’s how: If your capital losses exceed the gains (or if you have no capital gains), you can use your net loss to offset up to $3,000 of the current year’s ordinary income even though your ordinary income may be taxed at a higher rate than your capital gains. And, if your annual loss is more than $3,000, the excess can be “carried forward” to offset capital gains and ordinary income in future years.

Of course, waiting until December to harvest losses can give the declining assets time to rebound, eliminating the opportunity to use intra-year losses to a portfolio’s potential tax advantage. That rebound effect happens more than you think. For instance, in spite of average intra-year declines of 14.2%, annual returns for the S&P 500® Index were positive in 27 of the last 35 years.1

Source: FactSet, Standard & Poor’s, as of 12/31/2014. FactSet based on estimates, actual portfolio level returns may vary.

Crops ready for harvesting

Over the last year, the MSCI Emerging Markets Index has fallen 23%, and many investors likely have losses in their emerging markets positions.2 Harvesting these losses may give you an opportunity to re-evaluate how you invest in the less efficient emerging markets and to strategically refine your exposures. That can be particularly important given today’s divergent macroeconomic backdrop.

Harvesting: what you need to know

Whenever you harvest losses, it’s important to remember these rules of the road:

  1. The Internal Revenue Service’s Wash-Sale Rule prohibits taxpayers from claiming a loss on the sale of an investment if the same or “substantially identical” investment is purchased within 30 days before or after the sale date.3
  2. Rather than sit on the sidelines, you can use a “tax swap,” a placeholder that maintains your exposure to the asset class for 30 days. That way, your portfolio may benefit if the asset class advances.
  3. After 30 days, you can switch back to your original holding or stay invested in your new position.

And, whether you use a 30-day tax swap or decide on a more permanent portfolio replacement, ETFs can offer these potential advantages when harvesting losses:

  1. Tax efficiency. Because ETFs trade as baskets of securities, portfolio managers often don’t have to sell individual securities to meet shareholder redemptions. Therefore, redemptions tend not to create capital gains distributions for shareholders, reducing the chance of an unwelcome year-end capital gain tax bill.
  2. Diversification. Index ETFs provide broad exposure to an array of sectors, styles, industries and countries spanning virtually every asset class. This allows for either precise swaps for single stocks or broad exchanges for diversified exposures.
  3. Liquidity. Because ETFs trade throughout the day on an exchange, you can re-allocate into the market immediately after your sale.

Financial advisors interested in learning more about tax loss harvesting insights can visit SPDR® University to download Tax Loss Harvesting Time: The Crops and Tools for This Year’s Harvest. It offers insight from two leading tax-aware advisors on when to harvest losses and how to strive to create maximum value for clients.