How Well Does Tax-Loss Harvesting Work?

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Investors have access to multiple personalized indexing products, a key benefit of which is to allow for tax-loss harvesting (TLH). I analyze when TLH works and how helpful it is to returns.

Taxes are a fact of life, and for investors capital gains taxes are as well. In some years – when highly appreciated investments are sold – capital gains taxes can represent a large hit to investor’s post-tax income. An important aspect of capital gains taxes is that capital losses can offset current or future capital gains and up to $3,000 of current regular income. This feature of tax law creates an incentive for investors to “harvest losses,” that is to sell positions in securities that have lost money from when they were initially purchased (their tax basis).

An important consideration for tax-loss harvesting is the wash-sale rule, which says that once a security has been sold at a tax loss, that security and “substantially identical” securities cannot be bought for a period of at least 30 days before or after the tax-loss sale. (For example, SPY and VOO, both S&P 500 ETFs, would probably be considered substantially identical. Some further thoughts on this are in this article by Morningstar.) Such a purchase within this 61-day window counts as a wash sale. If a wash-sale occurs, the associated tax-loss is disallowed and is added to the cost basis of the bought security, which means the tax-loss is deferred rather than voided (unless the purchase takes place in an IRA account, in which case the cost basis is not adjusted).