Importance of Tax Loss Harvesting in Your Retirement Plan

Tax planning is something you need to focus on in retirement. But in retirement, you probably do not want to be buried in tax codes, credits, and complicated laws governing deductions. You want strategies that are simple, effective, and easy to manage. Tax-loss harvesting makes it to this list.

It is relatively straightforward to apply. It is also convenient. You do not need to change your financial plan to make it work. With the right guidance, it can seamlessly integrate into your retirement strategy and provide a way to save without adding to your stress.

So, is tax-loss harvesting worth it in retirement?

Let’s dig into how it works, the benefits, and the limitations, so you can decide if it is indeed a strategy you should be looking into.

What is tax-loss harvesting?

Tax-loss harvesting is a strategy that lets you use your losses to offset your gains and hence save on tax. When markets are volatile, the value of your investments can swing up and down. An investment may suddenly drop below the price you originally paid for it. But while this loss may be unnerving at first, it can help you if you employ the strategy of tax-loss harvesting.

Whenever you sell an investment like a stock, bond, Exchange-Traded Fund (ETF), index fund, or mutual fund, you could be looking at a taxable event. If you sold it for more than what you bought it for, you typically owe taxes on the profit. These profits are called capital gains.

If you have owned the investment for over a year, the profit is considered a long-term capital gain, which is subject to a lower tax rate, ranging from 0% to 20%. If you held it for a year or less, the profit is treated as a short-term capital gain, which is taxed at your regular income tax rate, which can be as high as 37%. Either way, a tax bill is waiting for you.

However, tax-loss harvesting helps you utilize your losses to offset some of those gains. You either reduce the amount of tax you owe or, in some cases, eliminate it altogether. It does not erase the fact that you lost money on an investment, but it does give you a direct tax benefit.

This strategy only applies outside of tax-advantaged retirement accounts like 401(k)s and Individual Retirement Accounts (IRAs), since gains and losses inside those accounts are not taxed in the same way. In taxable accounts, however, tax-loss harvesting can make a noticeable difference.

Taxes in retirement can really throw you off your game. With a fixed income, losses can feel like a big blow. That is why tax planning matters. Tax-loss harvesting allows you to use your annual investment losses to offset profits. Over time, these savings can help you stretch your retirement funds, providing more breathing room for emergencies and other expenses.

How does tax-loss harvesting work?

Say you invested in two stocks. Stock X did not go your way, and you sold it for a $10,000 loss. On the other hand, Stock Y did better, and you sold it for a $7,000 profit. Normally, that $7,000 gain would be taxable, and you would owe capital gains tax on it. But with tax-loss harvesting, the $10,000 loss can be used to cancel out the $7,000 profit. The result is zero taxable gains. And, just like that, you avoid paying tax on that $7,000.

But the story does not end there. Since your loss was bigger than your gain, you still have $10,000 – $7,000 = $3,000 left over. Tax rules allow you to use up to $3,000 of those unused losses to lower your regular income for the year. If your income tax rate is 30%, that $3,000 write-off enables you to save about $900 in taxes immediately.

In this example, you used up the entire leftover $3,000, so there is nothing to carry forward into future years. However, if your losses had been even larger, you would have been able to roll the excess forward and use it to offset gains or income in future tax years.

Without tax-loss harvesting, you would have owed $1,050 in taxes on that $7,000 gain, assuming a 15% long-term capital gains rate. With tax-loss harvesting, not only do you completely wipe out that $1,050 tax bill, but you also save another $900 on your regular income taxes. That is a total of $1,950 back in your pocket.

What are the rules of tax-loss harvesting you should know about?

If you are planning to use tax-loss harvesting in retirement, here are some rules you should know:

1. Annual limit

There is a cap on how much of your losses you can use to reduce your ordinary income taxes each year. According to the current rules, you can deduct up to $3,000 of your losses against your regular income on your tax return if you are filing as single, married filing jointly, or head of household. But if you are married and filing separately, that limit drops to $1,500. As a couple, you can still claim $3,000 together if both of you have losses.

Now, if your total capital losses are bigger than what you can use in a single year, say, for example, $4,000, you can carry them forward into future years until they are completely used up.

2. Wash-sale rule

The wash-sale rule is simple. If you sell an investment at a loss and then turn around and buy the same investment or something substantially identical within 30 days before or after the sale, that loss will not qualify for tax-loss harvesting. In this case, the loss will be recognized, but you will not be able to use it to offset your capital gains or reduce your taxable income.

Now, the tricky part is that the wash-sale rule does not just apply to the account where you sold the investment. For instance, let’s say you sell shares of a stock in your taxable brokerage account, but then your spouse buys the same stock in their account the following week. Or perhaps you move money into your IRA or 401(k) and accidentally repurchase the same investment within it. This will still be a wash sale. So, you have to think across all the accounts you and your household control, not just the one where you are doing your tax-loss harvesting.

The timing window is also important and often trips people up. You have a 61-day window to consider. This includes 30 days before the sale, the day of the sale, and 30 days after. So, if you bought a stock just two weeks before you sold it at a loss, and then you bought it back again after the sale, you have still created a wash sale.

So, how do you avoid this?

Patience is a virtue in this case, and the best thing you can do is to just wait. If you have sold an investment at a loss, wait at least 31 days before repurchasing it. Having said that, sometimes you may not be willing to wait. If you see an emerging market opportunity, you may want to take immediate action. Well, the good news is that the Internal Revenue Service (IRS) uses the phrase “substantially identical” in its wash sale rule. Now, this somewhat ambiguous term gives you some wiggle room.

For example, if you sell shares of a pharma company at a loss, you can buy shares of another company within the pharma sector without triggering the rule. They are in the same sector, sure, but they are not identical investments. The same logic works with mutual funds and ETFs. If you sell one small-cap stock fund, you can buy another fund that focuses on small-cap stocks without running afoul of the wash-sale rule.

However, if you are ever unsure, it is still a good idea to run your plan by a tax advisor and double-check it rather than lose out on savings.

3. State rules

State taxes can make tax-loss harvesting more complicated. While the federal rules are the same for everyone, each state has its own tax code. So, the benefits you get from tax-loss harvesting may look different depending on where you live. Some states follow federal rules closely, while others have their own limits or exceptions.

A tax professional who understands your state’s laws can walk you through the details. At the very least, you should double-check your state’s specific tax guidelines before employing tax-loss harvesting.

Pros and cons of tax-loss harvesting

Despite the apparent advantage of tax savings in retirement, tax-loss harvesting is not a suitable fit for all investment strategies. It can have its advantages, but it also has some drawbacks. Let’s discuss these in detail:

Reasons why tax-loss harvesting can be great for you in retirement

a. Deferral of taxes

One of the biggest reasons tax-loss harvesting can work in your favor during retirement is simple – it lets you defer taxes. When you sell investments at a loss and use the proceeds to offset your annual gains, you reduce the taxable gains you would otherwise report.

And, you can reinvest the proceeds into similar, but not identical, investments to stay in the market. This way, your portfolio does not lose its growth potential while you still lock in the tax benefit. The money you save this year can continue to grow in your account rather than being sent off as taxes.

Of course, the reality is that future gains usually outweigh harvested losses you will eventually realize. But deferring taxes today gives you extra breathing room and lets your investments grow without being stomped by an immediate tax bill. In retirement, this deferral can make your financial life feel a lot more manageable.

b. High limits and higher tax savings

Another significant advantage of tax-loss harvesting is that it does not stop at just offsetting your capital gains. The IRS also lets you use harvested losses to offset up to $3,000 of ordinary income per year and $1,500 if you are married and filing separately.

Ordinary income, like wages, salary, and your pension in retirement, is most likely going to be taxed at higher rates than capital gains. So being able to shave off a chunk of that income with harvested losses is like scoring an extra bonus. If you are in a 22% federal tax bracket, $3,000 of harvested losses can offer you a direct tax savings of $660 in a single year. In retirement, you could use this money to cover groceries, travel, or even healthcare expenses.

Even if you do not have a ton of realized gains in a particular year, a $3,000 deduction against ordinary income is still substantial.

c. Fairly simple to employ

The tax-loss harvesting strategy is fairly simple to use once you understand the basics. As a retiree, you can employ it on your own if you are comfortable keeping track of your investments and the rules, or you can take help from a financial advisor to make sure it is done correctly. Either way, it does not require advanced expertise.

The process is straightforward – you sell an investment that has gone down in value and then you reinvest the money in a similar but not “substantially identical” investment. That is really it. The rules are clearly laid out by the IRS, and while you need to be mindful of things like the wash-sale rule, once you understand the timelines, it is relatively easy to follow through.

Reasons why tax-loss harvesting doesn’t work

a. You actually need losses for it to work

This one sounds obvious, but tax-loss harvesting only works if you have investments that are in losses. If your retirement portfolio is all gains and no losses, there is nothing to harvest. In that case, you will simply owe tax on your earnings, and there will be no strategy to employ. It can feel a little frustrating, but without losses, the strategy does not exist.

b. The risk of higher taxes later

Harvesting losses does not get rid of taxes forever; it just defers them. You just end up pushing your tax bill into the future. If your tax rate stays the same, you have bought yourself some time and flexibility, which can be helpful in retirement. If your tax rate goes down in the future, you actually come out ahead. But if your capital gains rate increases down the line, you may end up paying more than you would have if you had just held onto your investments.

c. It is not effective in all scenarios

Tax-loss harvesting really shines in some situations but falls flat in others. For example, if you expect your capital gains rate to stay steady, it is mostly just a way to buy time. If you expect your rate to go down in the future, then it is a win. But if your rate goes up or if you do not even plan to sell much because your goal is to leave assets behind for heirs, it may not help you at all. Elderly investors with legacy goals, for instance, may prefer to hold onto their investments rather than play with short-term tax strategies.

The bottom line on tax-loss harvesting

Is tax-loss harvesting worth it in retirement?

Like any tool, tax-loss harvesting works best in specific circumstances. Before jumping in, understand your current and future tax picture to decide whether this strategy will actually pay off for you. Also, ensure you understand your state tax laws to avoid any unexpected issues when being employed.

And of course, it always helps to speak to a financial advisor who can guide you through the process. Our free advisor match tool can connect you with seasoned professionals who can devise a personalized tax strategy to reduce your taxes.

To learn more about the most suitable tax-saving strategies for your specific financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.