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Manage Taxes With Loss Harvesting

We all get satisfaction when we make money on the sale of a stock, yet these gains can come with the nasty surprise of hefty tax bills. Losses, on the other hand, can be hard to swallow. The good news is that losses may come with a silver lining in the form of potential tax benefits.

“Tax-loss harvesting,” as it is known, allows investors to offset gains realized in one investment with losses incurred in another.* The following hypothetical example illustrates how this technique can help reduce an investor’s tax liability.

Tax-Loss Harvesting: A Hypothetical Example

  • The hypothetical long-term loss from the sale of XYZ partially offsets the long-term gain from the sale of ABC. 
  • This example assumes a capital gains tax rate of 15 percent. This rate varies by filing status  and income. 
  • The offsetting loss results in a tax savings of $600. 
This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security. There is no assurance similar results can be achieved, and this information should not be relied upon as a specific recommendation to buy or sell securities. 

Some Dos and Don’ts of Tax-Loss Harvesting

Following a few general guidelines could help you take advantage of this opportunity and may help avoid running afoul of the IRS’s wash sale rule. Remember everyone's situation is different. Please consult a tax advisor for your individual situation. 

Do

  • Use the strategy for taxable accounts only, as there is no tax benefit to harvesting losses in a tax-deferred account
  • Replace a security sold for a loss with another similar (but not identical) security in order to maintain desired exposure
  • Consider the relative advantages and disadvantages of using ETFs, active mutual funds, or indexed mutual funds to replace a security sold for a loss
  • If losses exceed gains in any one year, carry over any unused losses to apply against gains in future years

Don't

  • Sell a security for a loss and then repurchase it within 30 days
  • Purchase a “substantially identical” security to replace one sold for a loss
  • Sell a security for a loss from a taxable account and then repurchase it within 30 days in a tax-deferred account 
  • Let taxes alone drive investment decisions – the decision to harvest losses should be made in concert with the overall investment plan. 

And Bear in Mind

As year-end approaches, take the opportunity to review each portfolio’s capital gains tax exposure as part of your holistic approach to financial planning. 

And following is an overview of some recent changes in tax law that you should keep in mind in tax planning.

Not So Sweet: SALT Tax Changes

  • Changes in the deductibility of state and local taxes (SALT) may alter the tax picture for investors in states with high property and/or state income taxes. 
  • SALT deductions now top out at $10,000, where previously there was no limit. 
  • This change highlights the importance of tax planning in the context of your clients’ overall financial situation.

The Long and Short of It

  • There’s a significant tax advantage to holding onto assets for longer than a year, since long-term cap gains tax rates (0%, 15%, 20%) are much lower than short-term cap gains tax rates (taxed as ordinary income). 
  • Most dividend income is taxed the same as long-term capital gains.
  • If losses exceed gains in a given year, they can be carried forward until gains are depleted.
  • Investors may also deduct up to $3,000 in losses from their income each year.
  • Taxes apply on gains from the sale of a residence (net of improvements and exclusions), yet losses on their sale cannot be deducted.

Watch Out for Wash Sales

The IRS’s wash sale rule is designed to keep investors from claiming artificial losses, so it’s critical to understand it if you’re planning to harvest losses.

The rule prohibits the sale of a security in order to claim a loss if the investor repurchases it – or a “substantially identical” security – within 30 days before or after the sale. Violating this rule could negate any potential tax benefits from the transaction. 

How does the IRS define “substantially identical” security? Unfortunately, they have not identified specific criteria.** Nevertheless, to determine the potential for a wash sale violation, there are some factors that investors may want to consider, including the degree of holdings overlap and the difference in prospective returns. The greater the holdings overlap and the more similar the prospective returns, the greater the possibility of a wash sale classification by the IRS.

Many investors consider ETFs as well as active and indexed mutual funds as effective tools to gain desired portfolio exposures. Yet it’s important to exercise caution to avoid violating the wash sale rule. The following framework provides an overview of the extent to which ETFs, active mutual funds, and index mutual funds may feature low portfolio overlap as well as differences in prospective returns under various scenarios.

Considerations for Tax-Loss Harvesting

Manage Taxes With Loss Harvesting

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*Long- and short-term capital gains are taxed at different rates. Long-term gains may only be offset by longer-term losses. Likewise, short-term gains may only be offset by short-term losses.

**As of 11/30/2018, the Internal Revenue Service has not released a definitive opinion regarding the definition of “substantially identical” securities and its application to the wash sale rule and ETFs. The information and examples provided are not intended to be a complete analysis of every material fact and are presented for educational and illustrative purposes only. Tax consequences will vary by individual taxpayer and individuals must carefully evaluate their tax position before engaging in any tax strategy. 

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice. 

IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. 

This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.