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Importance of Tax Loss Harvesting in Your Retirement Plan

Even in the best of times, not all your investments are going to be winners. However, even falling investment values have a silver lining. The losses you earn on your portfolio can be used to lower your tax liability and position your portfolio better for the future. This particular strategy is known as tax-loss harvesting. Many investors use this tax-loss harvesting strategy annually to offset realized gains with losses earned from some specific investments. Tax-loss harvesting can offer a huge tax benefit if properly applied.

Here is what you need to know about tax-loss harvesting and its importance in your retirement plan:

What is tax-loss harvesting?

Tax-loss harvesting strategy can help you minimize your yearly tax liability by offsetting your capital gains with specific investment losses. As per this tactic, you sell investments (such as stocks, mutual funds, exchange-traded funds, etc.) that have lost value to counterbalance any capital gains realized from other investments. You can also choose to replace the loss-bearing investments with reasonably similar options that meet your investment needs and asset allocation strategy. Moreover, tax-loss harvesting is useful in limiting short-term capital gains because they are taxed at a higher rate as compared to long-term capital gains. That said, it is now also useful to balance capital gains in the long-term too. This strategy is most suitable if applied during the initial life of a portfolio.

How does tax-loss harvesting work?

Tax-loss harvesting is based on a fundamental principle – increase portfolio losses to minimize the total burden of taxes. For example, if you invest in equity or equity-based assets, you will earn capital gains or losses depending on the market situation. In the case of capital gain, you would need to pay taxes on the earnings according to your investment bracket. However, if at the same time, some of your assets are underperforming or accruing losses, you can reduce the total capital gain tax liability by selling those loss-bearing assets. The tactic can be applied for short-term gains (earned on investments held for one year or lesser) or long-term gains (earned on investments held for longer than one year).

What are applicable rates for tax-loss harvesting?

For 2020, federal tax rates for long-term capital gains are 20%. And the highest marginal rate for regular income is 37%. Since short-term capital gains are taxed at the marginal tax rate of normal income, the effective tax rate for short-term capital gains is 37%. That said, even though all investors can benefit from the tax-loss harvesting technique, this strategy is more beneficial for high-income investors.

Ideally, in a year, if your capital losses are more than capital gains, you can reduce your taxable annual income by $3,000 or your total net losses, whichever is lower. However, if you are married and filing a tax return separately, you can reduce your taxable income by not more than $1,500 in losses. That said, you can carry forward your unused loss amount into the future years in case your net losses exceed $3,000 in the current year.

What is the importance of tax-loss harvesting in your retirement plan?

Tax-loss harvesting is particularly significant for your retirement plan because of the many advantages it offers. Some of the most important benefits that tax-loss harvesting offers include:

  • Portfolio rebalancing: As per experts, as you near the age of retirement, your portfolio should constitute more safe income assets rather than risky ones like stocks. The motto at this stage is often capital preservation and not higher returns. This approach can be better applied through a tax-loss harvesting strategy. With the aim to rebalance your portfolio to reduce overall risk, you can let go of investments that are risky and have also been underperforming. In place of these assets, you could choose to opt for investment options that are less risky and also match your retirement goals and asset allocation strategy. This method of portfolio rebalancing not only allows you to restructure your portfolio to your retirement needs but also helps you minimize capital gains taxes since you would be counterbalancing high returns with losses on investments.

  • Defer taxes: The main objective of tax-loss harvesting is to defer income taxes way into the future. When you shift your tax burden for a later time, you are likely to pay lower taxes because typically your income tax liability in the retirement years will be lower, owing to less income. Further, delaying paying taxes helps your portfolio to grow faster and take better advantage of the power of compounding, as compared to a scenario, where you pay taxes by withdrawing money from your portfolio in each year that you realize gains.
  • For example, assume that you have a mutual fund that continues to increase in value each year for 20 years. During this period, you can use tax-loss harvesting tactics to offset your capital gains and defer final taxes for the future. By the end of 20 years, your funds grow by four to five times your actual investment, more so because you did not pay any taxes on the realized gains annually. This approach works like a tax-sheltered retirement account although your money is an ordinary taxable investment account.

  • Reduced regular tax liability: In addition to helping you minimize your capital gain liabilities, the tax-loss harvesting method also aids you in reducing the taxes on your regular income. So, even if you do not have any capital gains to offset, you can always use this strategy to limit your regular income tax liability. For example, you own stocks of XYZ company that you bought at $10,000. These stocks are now worth $7,000. You sell these shares and accrue a loss of $3,000. You then use this money to buy stocks of another more profitable company that better suits your retirement objectives. You can use this $3,000 capital loss to reduce your taxable income for the year. So, in case your marginal income tax rate is 30%, you can get a current income tax benefit of nearly $900 ($3,000*30%). Additionally, you can invest your tax-savings back in the market. Assuming you get an average return of 6% each year, if you reinvest $900 you can potentially gain $35,000 after 20 years.

  • Improved investment performance: Tax-loss harvesting has a positive impact on your investment returns in the long-run. According to a study, the after-tax investment returns increased by more than 1.55% each year between 2000 and 2013. So, if the study is accurate, you can improve your investment performance by an average of 1.55%. This means that if your returns were 7%, you can likely earn 8.55% in a year by applying the tax-loss harvesting method.

To sum it up

Overall, tax-loss harvesting is a beneficial strategy for retirement planners. However, it is critical to understand the deeper aspects of the approach like the wash-sale rule that limits the buyback of similar or substantially similar assets, which were earlier sold for tax-harvesting purposes, for 30 days. Apart from this, the tax-loss harvesting approach can get slightly intimidating and difficult to apply in the case of multiple securities. Hence, it is advisable to consult a professional financial planner to guide you to make the best use of this opportunistic method.

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