What is tax-loss harvesting, and how can it help your portfolio? Learn more about the rules and strategies, and see an example of tax-loss harvesting in action.
Should you consider tax-loss harvesting? It’s a process designed to take advantage of the IRS tax-loss harvesting rule that allows realized losses to offset the realized gains in your taxable portfolio. This process may potentially lower your tax liability—on the condition that all the trades are closed out in the same calendar year.
Sound complex? Let’s break it down.
As most investors know, the more positions you hold, and the longer you’ve been investing, the more likely you are to sustain a capital loss somewhere in your taxable portfolio. And at the same time, you might have realized taxable gains. But the IRS lets you match those gains and losses, and this can potentially lower your tax bill. Even if your losses exceed your gains, you can still claim capital losses—up to $3,000 per calendar year—until the entire amount of capital losses has been claimed.
At its core, tax-loss harvesting is the process of seeking out and culling losing positions to offset capital gains. This can be a manual process—as in the example below. But some investors choose to enroll in an automated tax-loss harvesting program (more on that in a bit).
To illustrate the tax-loss harvesting strategy in its most basic form, consider two investors: Investor Allen and Investor Bea.
In this scenario, Investor Allen has a $1,000 profit on his ABCD trade, which will be subject to capital gains tax.
In this scenario, although Investor Bea has the same $1,000 profit as Investor Allen, because Investor Bea sold XYZ before the end of the year, the $1,000 loss on the stock is considered “realized” and may be used to offset ABCD’s gains—potentially eliminating capital gains tax.
If you don’t have any capital gains or if you have more losses than gains, you can use the losses to offset up to $3,000 of other taxable income per year. After using your losses to offset capital gains and income, you can use any remaining losses to offset gains or income in later years (under current tax laws).
Now that you’ve got the basics, let’s take it a step further and add automation.
For investors with taxable accounts who are invested in an ETF portfolio managed by TD Ameritrade Investment Management, LLC (TDAIM), executing on a tax-loss harvesting strategy is automated and done at no extra cost. The portfolio is monitored daily, and when a tax-loss harvesting opportunity is identified, the position will automatically be sold and the proceeds invested into a replacement security designed to maintain the portfolio’s target allocation.
Sometimes an opportunity pops up in, say, October that may not be there at the end of the year. With an automated tax-loss harvesting service (as opposed to a periodic or end-of-year manual scan), opportunities can be acted on as they occur.
Investors should educate themselves about the IRS’s wash sale rule, which prohibits them from claiming a tax loss if they open the same security position just recently closed (or a substantially similar security) either 30 days before or 30 days after closing a position for a loss. To evaluate whether you violated the wash sale rule, the IRS reviews the trading activity for all of your accounts.
In other words, the IRS looks at trades you place in other accounts at TD Ameritrade, at other brokerage firms, and in IRAs or Roth IRAs, as well as transactions your spouse made and transactions by a business entity you control to determine if you violated the wash sale rule.
TD Ameritrade Investment Management’s tax-loss harvesting service only scans your managed portfolio on an account-level basis (not all of your TD Ameritrade Investment Management portfolios collectively). Each eligible portfolio must be enrolled separately in the tax-loss harvesting service; the firm doesn’t have any transparency into your trading activity in brokerage accounts that you may have at TD Ameritrade or at other financial institutions.
So a trade placed in one account may inadvertently create a wash sale in another account. You should be aware of investments in all of your investment accounts to determine if you run the risk of violating the wash sale rule.
There are a couple other potential advantages to tax-loss harvesting. First off, it can help minimize complexity. It’s a wealth management strategy that typically requires either the resources of a full-time advisor to manage or a significant amount of time spent by a client to effectively manage on their own.
Strategic tax-loss harvesting can help make your portfolio more efficient and potentially improve your after-tax returns. Just remember, as with any tax-related questions, you should talk to your tax professional, who can advise you on what’s appropriate for your specific tax situation.
TDAIM does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances as to whether our TDAIM tax-loss harvesting feature is appropriate for you. This feature generally would be more beneficial to investors in higher tax brackets and high-tax states.
TDAIM goes through a rigorous due diligence process to select securities to replace those sold for tax-loss harvesting purposes. We seek replacement securities that meet TDAIM’s high standards and keep your portfolio in line with its target allocation.
TDAIM will no longer be accepting new clients into any managed portfolios. If you’re interested in a managed portfolio, please visit our affiliate Schwab for more information.
The tax-loss harvesting feature is currently only available with the TDAIM ETF-based portfolios in taxable TD Ameritrade investing accounts. Tax-loss harvesting is not appropriate for all investors. Investing in securities involves risk of loss that the client should be prepared to bear. TDAIM does not represent or guarantee that the objectives of the tax-loss harvesting feature will be met. The performance of the replacement securities purchased through the TDAIM tax-loss harvesting feature may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes. TDAIM only reviews each account that is managed by it individually to help ensure that your account does not violate the “wash sale” rule. When you enroll in the tax-loss harvesting (TLH) feature, the enrollment is on an account basis and does not apply to other TDAIM portfolios you may have. Each eligible TDAIM portfolio must be enrolled separately in the TLH feature. Accordingly, you are responsible for monitoring your brokerage accounts and your spouse’s brokerage accounts at TD Ameritrade or elsewhere to ensure that transactions in the same security or a substantially similar security do not create a wash sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.
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