Understand the IRS rules that allow realized capital losses to offset up to $3,000 in realized capital gains per calendar year
See an example of tax-loss harvesting in action
Learn how an automated tax-loss harvesting service can help investors be more tax efficient and potentially improve after-tax returns
Looking to pursue an optimal, tax-efficient portfolio balance? Consider tax-loss harvesting. It’s a process designed to take advantage of an IRS rule allowing realized losses to offset the realized gains in your taxable portfolio. This process may potentially lower your tax liability—on the condition that all the trades are closed out in the same calendar year.
Sound complex? Let’s break it down.
What Is Tax-Loss Harvesting? Here Are the Basics
As most investors know, the more positions you hold, and the longer you’ve been investing, the more likely you are to sustain a capital loss somewhere in your taxable portfolio. And at the same time, you might have realized taxable gains. But the IRS lets you match those gains and losses—up to $3,000 per calendar year—and potentially lower your tax bill.
At its core, tax-loss harvesting is the process of seeking out and culling losing positions to offset capital gains. This can be a manual process—as in the example below. But some investors choose to enroll in an automated tax-loss harvesting program (more on that in a bit).
To illustrate the tax-loss harvesting strategy in its most basic form, consider two investors, Investor Allen and Investor Bea.
- Purchases 1,000 shares of ABCD stock at $10/share on the first trading day of the year.Purchases 1,000 shares of XYZ stock at $10/share on the first trading day of the year.Sells ABCD for $11/share on the last trading day of the same year.Holds XYZ stock, which closes the year at $9/share.
In this scenario, Investor Allen has a $1,000 profit on his ABCD trade, which will be subject to capital gains tax.
- Purchases 1,000 shares of ABCD stock at $10/share on the first trading day of the year.Purchases 1,000 shares of XYZ stock at $10/share on the first trading day of the year.Sells ABCD for $11/share on the last trading day of the same year.Sells XYZ for $9/share on the last trading day of the same year.
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In this scenario, although Investor Bea has the same $1,000 profit as Investor Allen, because Investor Bea sold XYZ before the end of the year, the $1,000 loss on the stock is considered “realized” and may be used to offset ABCD’s gains—potentially eliminating capital gains tax.
If you don’t have any capital gains or if you have more losses than gains, you can use the losses to offset up to $3,000 of other taxable income per year. After using your losses to offset capital gains and income, you can use any remaining losses to offset gains or income in later years (under current tax laws).
Now that you’ve got the basics, let’s take it a step further and add automation.
Automated Tax-Loss Harvesting with Managed Portfolios
For TD Ameritrade Investment Management, LLC clients with taxable accounts who are invested in a managed ETF portfolio, executing on a tax-loss harvesting strategy is automated and done at no extra cost. The portfolio is monitored daily, and when a tax-loss harvesting opportunity is identified, the position will automatically be sold and the proceeds invested into a replacement security designed to maintain the portfolio’s target allocation.
Sometimes an opportunity pops up in, say, October that may not be there at the end of the year. With an automated tax-loss harvesting service (as opposed to a periodic or end-of-year manual scan), opportunities can be acted on as they occur.
Tax-Loss Harvesting with Managed Portfolios: An ETF Example
To better understand how tax-loss harvesting works, imagine a scenario in which someone invests $100,000, putting $60,000 in ETF A and $40,000 in ETF B.
At the end of one year, ETF A has declined by $7,000 and is now worth $53,000. But ETF B has risen by $10,000 and is now worth $50,000.
Without tax-loss harvesting, the client has a realized gain of $10,000 from ETF B and has a potential tax bill of $1,500 (assuming the client sells the shares and pays the 15% capital gains tax on the profit).
With tax-loss harvesting, TD Ameritrade Investment Management has been monitoring the two ETFs daily all year, selling ETF A to offset gains from ETF B. At the end of the year, instead of paying a $1,500 tax, the investor has only a potential tax bill of $450, for a potential tax savings of $1,050.
Want to see it as a flow chart? Take a look at figure 1.
FIGURE 1: WITH AND WITHOUT TAX-LOSS HARVESTING. Hypothetical example for illustrative purposes only.
Beware of the Wash Sale Rule
Investors should educate themselves about the IRS’s wash sale rule, which prohibits them from claiming a tax loss if they repurchase the same security (or a substantially similar security) either 30 days before or 30 days after selling a security for a loss. To evaluate whether you violated the wash sale rule, the IRS reviews the trading activity for all of your accounts.
In other words, the IRS looks at trades you place in other accounts at TD Ameritrade, at other brokerage firms, and in IRA or Roth IRA accounts, as well as transactions your spouse made and transactions by a business entity you control to determine if you violated the wash sale rule.
TD Ameritrade Investment Management’s tax-loss harvesting service only scans your managed portfolio on an account-level basis (not all of your TD Ameritrade Investment Management portfolios collectively). Each eligible portfolio must be enrolled separately in the tax-loss harvesting service; the firm doesn’t have any transparency into your trading activity in brokerage accounts that you may have at TD Ameritrade or at other financial institutions.
So a trade placed in one account may inadvertently create a wash sale in another account. You should be aware of investments in all of your investment accounts to determine if you run the risk of violating the wash sale rule.
Tax-Loss Harvesting for Your Portfolio
There are a couple other potential advantages to tax-loss harvesting. First off, it can help minimize complexity. It’s a wealth management strategy that typically requires either the resources of a full-time advisor to manage or a significant amount of time spent by a client to effectively manage on their own.
Strategic tax-loss harvesting can help make your portfolio more efficient and potentially improve your after-tax returns. Just remember, as with any tax-related questions, you should talk to your tax professional, who can advise you on what’s appropriate for your specific tax situation.
How to Enroll
Automated tax-loss harvesting is available to all Essential Portfolios and Selective Portfolios. Although each of these programs has its own investment minimum, there’s no minimum enrollment threshold for tax-loss harvesting. Qualified clients can enroll by contacting a TD Ameritrade Investment Management Portfolios Specialist.
Once enrolled, TD Ameritrade Investment Management manages the process so you don’t have to. At any point, you can turn off the feature if you no longer desire it.
For more information about the TD Ameritrade Investment Management tax-loss harvesting service, contact a Portfolios Specialist at 800-665-1978.
Learn more by watching the short video below.
Other Key Considerations
TD Ameritrade Investment Management does not provide tax advice. We suggest you consult with a tax-planning professional with regard to your personal circumstances as to whether our TD Ameritrade Investment Management, LLC tax-loss harvesting feature is appropriate for you. This feature generally would be more beneficial to investors in higher tax brackets and high-tax states.
TD Ameritrade Investment Management, LLC goes through a rigorous due diligence process to select securities to replace those sold for tax-loss harvesting purposes. We seek replacement securities that meet TD Ameritrade Investment Management’s high standards and keep your portfolio in line with its target allocation.
The tax-loss harvesting feature is currently only available with the TDAIM ETF-based portfolios in taxable TD Ameritrade Investing Accounts. Tax-loss harvesting is not appropriate for all investors. Investing in securities involves risk of loss that the client should be prepared to bear. TDAIM does not represent or guarantee that the objectives of the tax-loss harvesting feature will be met. The performance of the replacement securities purchased through the TDAIM tax-loss harvesting feature may be better or worse than the performance of the securities that are sold for tax-loss harvesting purposes. TDAIM only reviews each account that is managed by it individually to help ensure that your account does not violate the “wash sale” rule. When you enroll in the tax-loss harvesting feature, the enrollment is on an account basis and does not apply to other TDAIM portfolios you may have. Each eligible TDAIM portfolio must be enrolled separately in the TLH feature. Accordingly, you are responsible for monitoring your brokerage accounts and your spouse’s brokerage accounts at TD Ameritrade or elsewhere to ensure that transactions in the same security or a substantially similar security do not create a wash sale. The wash sale rule postpones losses on a sale, if replacement shares are bought around the same time.
Prior to enrolling in the tax-loss harvesting feature, please read TDAIM’s white paper.