With just a few trading days remaining in 2023, tax-loss harvesting can be a useful strategy to improve your after-tax investment outcomes. Researchers have suggested that this strategy can improve returns by about 1% each year. The paper is ‘An Empirical Evaluation of Tax-Loss Harvesting Alpha’ by MIT researcher Shomesh Chaudhuri and others looking at returns for the 1926 to 2018 period for the S&P 500.
This approach may be applicable if you invest in stocks via a U.S. taxable account. Tax loss harvesting can realize taxable losses, without materially changing portfolio performance. This process can push the payment of capital gains taxes into the future. That delayed tax payment may improve your after-tax investment returns as you can earn a return on that money for more time rather than 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 likely realize capital gains and losses as you buy and sell investments over time. If you only invest 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 be useful to you.
Tax loss harvesting focuses on realizing taxable losses, especially short-term capital losses, to offset capital gains that you might otherwise have to pay.
The way it works is by looking across your account for investments that you have held for under a year and are worth less than you paid for them. These investments may qualify for short-term capital losses. You can then sell these shares to realize that capital loss, which could then offset capital gains elsewhere in your portfolio.
Wash Sales
Importantly, wash sales may disqualify a trade from achieving a capital loss. Investments that you have purchased in the past 30 days, or that you repurchase 30 days after selling can be treated as a wash sale. Wash sales can negate the benefits of tax-loss harvesting, as it may prevent a capital loss. Therefore when tax loss harvesting if you sell an investment, you must buy something different with the proceeds. That can mean that if you sell shares in Coca-Cola, that you buy shares in Pepsi, for example, as repurchasing Coca-Cola shares within 30 days could trigger a wash sale.
Other Caveats
Whether tax loss harvesting is useful to you also depends on your tax position. If you aren’t on track to pay income taxes anyway, then tax loss harvesting may not bring any benefits. If you aren’t paying taxes in the first place then offsetting them with capital losses may not be any help.
Also, a individual tax payer can offset as much in capital gains as they wish, but absolute losses from a tax loss harvesting strategy can not exceed $3,000 each year for an individual taxpayer.
A Recap
Any tax loss harvesting for your 2023 taxes must take place before the calendar year ends. That’s different to some other tax strategies that have a later deadline. This means that there are only a few trading days remaining in 2023 to consider implementing the strategy.
However, of course, the strategy can be applied in 2024 as well, but will apply for the 2024 tax year. Now may be a good time to look for losing investments that you purchased in 2023, and have held for over 30 days in a taxable account. If you sell them and replace them with a similar, but not identical investment, doing so may offset some capital gains payment in your taxable account.
Alternatively, doing this may create an investment loss of up to $3,000 to offset income tax payments. This process of pushing your capital gains tax payments further into the future may improve your overall investment outcomes.