When an investment declines in value, understanding the tax implications can bring another perspective to the conversation about what comes next.
When you look at your portfolio and see an investment worth less than you paid for it, it’s natural to wonder whether to give it more time or consider a change. That question may bring you back to why you invested, when you expect to need the money and how comfortable you feel with the uncertainty along the way.
There may also be a tax consideration to explore. In certain circumstances, selling an investment at a loss can help reduce taxes on investment gains. This approach is known as tax-loss harvesting, and its usefulness depends on how it fits with the rest of your financial life.
At Amida, we would begin with that wider picture, allowing the potential tax benefit to sit alongside your investment intentions and the responsibilities your wealth supports.
Understanding the potential benefit
A decline in an investment’s value generally becomes a realized capital loss when you sell it for less than its cost basis, which is usually its purchase cost, adjusted where necessary. In a taxable investment account, an eligible loss can offset taxable capital gains.
If losses exceed gains, a limited amount may also reduce other taxable income, such as your salary. The annual limit is generally $3,000, or $1,500 if you are married filing separately, with unused losses generally carried forward to future years.
The potential saving depends partly on the gains being offset. Tax rules distinguish between short-term and long-term gains and losses, based generally on whether the investment was held for one year or less, or longer than one year. Your tax professional can explain how those categories apply to your circumstances. [IRS capital gains and losses guidance]
These distinctions help explain why the same investment loss can have different tax outcomes for different people. The deduction reduces the amount subject to tax; it does not reimburse the loss itself.
This strategy applies to taxable investment accounts. Selling an investment at a loss within an IRA or 401(k) does not create the same capital-loss deduction.
The purchases surrounding a sale
Before a loss can be used, the timing of related purchases needs to be considered.
Under the wash-sale rule, a loss deduction is disallowed to the extent that you purchase the same investment, or one considered “substantially identical,” within 30 days before or after the sale. Including the sale date, this creates a 61-day window.
Purchases in other accounts, certain purchases by your spouse and automatic dividend reinvestments can affect the outcome. A disallowed loss is often deferred through an adjustment to the replacement investment’s cost basis, although an IRA or Roth IRA replacement can cause the loss to be permanently disallowed. [IRS wash-sale guidance]
This is a useful place to involve your advisors before making a change. Reviewing the proposed sale together with recent and scheduled purchases can help them understand how the transactions connect.
Staying connected to your investment intentions
An investment can decline in value while still representing an area of the market you want in your portfolio. If selling is appropriate, the next conversation is how that change would affect your diversification, your allocation and the risk you are comfortable taking.
It may be possible to choose a replacement that serves a similar investment purpose without being substantially identical. That distinction requires care, and a different fund name or provider alone does not resolve it. Waiting before buying the original investment again also involves considering market movements during the time away.
Your advisors can help you explore those choices, including costs and differences between investments. A helpful question to keep in view is whether the portfolio would continue to reflect the reasons you invested in the first place.
Looking beyond this year’s return
The potential benefit also deserves a longer view. If you sell at a loss and purchase a replacement with a lower cost basis, a later sale could produce a larger taxable gain if that investment grows.
Tax-loss harvesting therefore often involves postponing tax. That can have value because money that would otherwise have gone toward taxes remains available in the meantime. The eventual tax outcome will depend on future circumstances, including the rate that applies when a gain is realized.
Your expected use of the money and your intentions for passing on wealth can also influence the conversation. These are areas to explore with your wealth advisor and qualified tax and estate professionals, so that a decision made today remains connected to what you hope your wealth will support over time.
Year-end fund distributions add another consideration. A fund can distribute taxable capital gains even when your own investment in it has declined in value. Reviewing expected distributions alongside potential losses helps bring the full picture into view. [IRS guidance on investment income and expenses]
Bringing the conversation back to you
You don’t need to understand every calculation before asking whether tax-loss harvesting could be relevant to your portfolio. The conversation might begin with a few questions:
- Could any investment losses help offset gains we have already realized?
- How would selling affect the way our portfolio supports our needs and intentions?
- What could the decision mean for our taxes now and in the years ahead?
At Amida, we welcome these conversations because they give us an opportunity to consider the details in the context of your life. If you’re wondering how an investment loss fits into your wider financial picture, we invite you to schedule a conversation. Together with your tax professional, we can explore the possibilities and help you approach the decision with greater clarity.
