Tax-Loss Harvesting Isn’t Just for Downturns. Here’s Why

Key Concepts

• Tax Loss Harvesting: Selling investments with unrealized losses to offset capital gains and potentially ordinary income.
• Wash Sale Rule: IRS regulation preventing investors from selling a security at a loss and buying a "substantially identical" security within a specific timeframe (30 days before or after the sale) to avoid artificial losses.
• Substantially Identical Security: Not precisely defined by the IRS, but generally refers to securities with very similar characteristics or tracking the same index.
• Capital Gains: Profits from selling an asset for more than its purchase price.
• Ordinary Income: Income from wages, salaries, and other sources, taxed at a higher rate than capital gains.
• Asset Allocation: The distribution of an investment portfolio across various asset categories, such as stocks, bonds, and real estate.
• Rebalancing: The process of adjusting an investment portfolio to maintain its target asset allocation.
• 60/40 Portfolio: A traditional investment strategy allocating 60% to stocks and 40% to bonds.
• Growth Stocks: Stocks of companies expected to grow at an above-average rate compared to other stocks.
• Value Stocks: Stocks that appear to be trading for less than their intrinsic or fundamental value.
• Taxable Brokerage Account: An investment account subject to capital gains taxes on profits.
• Tax-Deferred Account (e.g., 401k, IRA): Investment accounts where taxes on gains are postponed until withdrawal.
• Required Minimum Distributions (RMDs): Minimum amounts that must be withdrawn annually from certain retirement accounts starting at a specific age (typically 73).

Tax Loss Harvesting and Portfolio Rebalancing for Year-End Cleanup

This segment of "Investing Insights" hosted by Ivana Hampton features Amy Arnot, a portfolio strategist at Morningstar Inc., discussing two key strategies for year-end portfolio management: tax loss harvesting and rebalancing. The discussion highlights the current market environment, where the Morningstar US market index is up approximately 15% year-to-date through mid-November, indicating strong overall performance. However, Arnot emphasizes that performance varies significantly across sectors and individual securities, creating opportunities for both winners and losers within portfolios.

Tax Loss Harvesting Explained

1. Definition and Mechanism: Tax loss harvesting involves selling investments (stocks or funds) that have experienced unrealized losses. The realized loss can then be utilized in several ways:

• Offsetting Ordinary Income: Up to $3,000 of ordinary income can be offset in the current tax year.
• Offsetting Capital Gains: Realized capital gains in the current tax year can be fully offset by these losses.
• Carrying Forward Losses: Any remaining losses can be carried forward indefinitely to offset future capital gains.

2. Account Suitability: Tax loss harvesting should exclusively be conducted within taxable brokerage accounts. Retirement accounts like 401(k)s and IRAs are not suitable because transactions within them do not have immediate tax implications. Selling assets in these accounts does not trigger capital gains taxes, and withdrawals are taxed as ordinary income upon retirement.

3. Impact of Up Markets: While strong market performance (like the current upswing) can make it harder to identify losses, it's not impossible. Arnot explains that losses can still exist if an investor purchased a security at a higher price some time ago. For offsetting long-term capital gains, it's crucial to use long-term capital losses, meaning the security must have been held for at least one year.

4. Identifying Loss Opportunities: Even in a strong market, specific sectors and stocks may have experienced losses. Arnot points to sectors like energy, real estate, consumer defensive, and basic materials as potential areas to explore. She provides examples of individual stocks that have shown losses over the past one or two years, including United Health Group, PepsiCo, Pfizer, Adobe, and Comcast. However, she stresses that the exact purchase date and price are critical for determining if a loss exists. Investors can find this information on their brokerage account statements.

5. Mutual Funds and ETFs: While most mutual fund categories show gains year-to-date, Arnot suggests looking into areas like small cap blend, small cap value, consumer defensive, real estate, and potentially long-term government bonds (if purchased years ago). She notes that widely held, larger funds may have fewer unrealized losses, but specialty areas like inverse leveraged funds or miscellaneous sector funds might offer more opportunities.

6. Wash Sale Rule Compliance: A critical aspect of tax loss harvesting is adhering to the IRS's wash sale rule. This rule prevents investors from selling a security at a loss and immediately repurchasing the same or a "substantially identical" security. This is to prevent the creation of artificial losses while maintaining economic exposure. To avoid violating this rule, investors must wait at least 30 days before or after the sale to buy a substantially identical security. Arnot clarifies that selling a fund tracking one index and buying a fund tracking a different index is generally acceptable. Similarly, selling a stock in a sector and buying another stock in the same sector (as long as it's not a different share class of the same stock) is usually permissible.

7. Strategic Use of Losses and Gains: Beyond offsetting losses, Arnot suggests being strategic about capital gains. In years with lower personal income, investors might be in a lower tax bracket for capital gains. For instance, married couples filing jointly with taxable income below approximately $97,000 may pay 0% on capital gains. In such scenarios, it can be beneficial to strategically realize capital gains.

Portfolio Rebalancing for Asset Allocation

1. Definition and Purpose: Rebalancing involves comparing an investment portfolio's current asset mix to its target asset allocation. Over time, market fluctuations cause some asset classes to grow more than others, leading the portfolio's mix to drift from its intended balance. Rebalancing aims to bring the portfolio back to its target levels, not necessarily to enhance returns, but primarily to control risk.

2. Emotional Challenges: Rebalancing can be emotionally challenging because it often requires selling assets that have performed well (and are thus over target) and buying into assets that have underperformed. Investors may be reluctant to sell winners, fearing they might miss out on further gains.

3. Historical Performance and Portfolio Drift: Arnot illustrates how portfolios can drift significantly without rebalancing:

• 60/40 Portfolio: A portfolio held for 10 years without rebalancing would have shifted from 60% stocks/40% bonds to approximately 80% stocks/20% bonds.
• Growth vs. Value: Over the past decade, growth stocks have outperformed value stocks by about 5 percentage points annually.
• US vs. International Stocks: US stocks have outperformed non-US stocks by approximately 7 percentage points annually over the last 10 years, despite non-US stocks outperforming year-to-date in 2025.

These trends suggest that portfolios left unmanaged for extended periods are likely to be overweight in growth stocks and US stocks relative to their targets.

4. Strategies for Restoring Balance:

• Overall Portfolio View: Investors should assess the asset mix across all their accounts, not just individual ones.
• Tax-Deferred Accounts: Rebalancing within tax-deferred accounts (like 401(k)s or IRAs) is advantageous as it avoids tax consequences.
• Required Minimum Distributions (RMDs): Individuals subject to RMDs (typically starting at age 73) can strategically sell assets that have appreciated and are over target to meet their distribution requirements, thereby helping to rebalance the portfolio.
• Gradual Approach in Taxable Accounts: For significant adjustments needed in taxable accounts without realizing large gains, investors can direct new contributions towards underweighted asset classes. This is a slower but effective method to rebalance over time.

Conclusion and Takeaways

Arnot emphasizes that both tax loss harvesting and portfolio rebalancing are crucial "administrative tasks" that, while potentially time-consuming, offer significant benefits for the future. Tax loss harvesting helps reduce the tax burden during tax season, while rebalancing ensures that the portfolio's risk exposure remains aligned with the investor's goals, especially in the event of a market downturn. The core message is that these actions are about "helping your future self."