A Closer Look at Tax-Loss Harvesting and Its Limitations

Read the full blog below to learn more.

This week’s insight focuses on the losers – your portfolio’s underperformers, that is.

You’re probably familiar with tax-loss harvesting (TLH), a common planning technique in which an investor sells underperforming positions in their non-retirement portfolio. This strategy is performed to either offset existing taxable capital gains or capture an income tax deduction of up to $3,000. Individual investors have until December 31 to execute such moves, and it’s a practice we consider and often undertake for our clients. Still, don’t expect to get rich with TLH.

For one thing, we do not believe in constantly moving in and out of investments. Not only does this kind of market timing typically result in subpar long-term returns, but it also drives up what you owe Uncle Sam through higher short-term capital gains tax. Daytraders may find it more advantageous to “realize” their losses, provided they were profitable with their strategies throughout the year. Since we primarily invest through tax-efficient strategies for the long haul, though, we don’t have to worry so much about nasty short-term capital gains tax.

What’s more, the $3,000 capital loss deduction is no longer as significant as it once was. You see, the Internal Revenue Service (IRS), in their infinite wisdom, established the $3,000 loss limit back in 1978, which was substantial at the time, roughly equivalent to the cost of a decent small car. However, this cap has not been adjusted for inflation (if it were, you could reduce your taxable income by upwards of $15,000 in 2023 dollars!). Additionally, for married tax filers, the deductible loss limit remains at $3,000; it is not doubled, as is the case with many other limits in the IRS Code.

Finally, you must be careful and considerate with TLH. We’ve seen novice investors sell quality funds to claim a loss, only to purchase a suboptimal position that they become stuck with when prices rise (lest they sell for a taxable gain). To prevent a “wash sale” which disallows the capital loss, you cannot repurchase the same investment you sold at a loss within 30 days.

So, while tax-loss harvesting is a useful strategy this time of year, it should not serve as the primary motivator to shake up your portfolio.