So, what is it exactly? Tax-loss harvesting is one of those tricky concepts that seems insane at first. The idea is to purposely sell investments that have gone down in value so that you lose money. The reason? To save money on taxes!
You might be wondering why you’d do that. After all, the mutual fund that had decreased in value might rebound, but now you’ve sold it and you’ll miss out. It’s important to remember that tax-loss harvesting is a two-step process. The first step is to sell losing investments. The second step is to buy an investment that is pretty similar. That second step makes it likely that, if the market for the old investment goes back up, you’ll still reap the rewards with your new investment. Maybe we should say that it’s two steps plus an asterisk. And the asterisk is this: The investments you buy and sell can’t be too similar. If they are, it looks like you’re cheating the government out of the taxes you owe. If you sell an ETF that follows U.S. stocks on the Dow Jones Industrial Average, you can buy another ETF that tracks U.S. stocks, but you’ll have to do it on a different exchange.
What are the pros? Aside from saving on your tax bill, tax-loss harvesting can increase your gains through the magic of compounding. You see, there is an argument that tax-loss harvesting is just a way to push your tax bill back a few years. If you pay later instead of now, you can make money off of the money you’d have otherwise turned over to Uncle Sam. It’s like a nice, interest-free loan from the government.
And you don’t have to take the loss on your taxes right away — you can apply it to the last three years or forward indefinitely. So if you know you have a huge capital gains tax bill coming up in the next few years, tax-loss harvesting when the markets are down will mean a nice tax credit that can be used in the future.
Is there anything to be careful about? Don’t do this in your Traditional or Roth IRA! As neither of these accounts are subject to capital gains, performing tax-loss harvesting in these accounts results in…well, nothing. Since there is no capital loss from these accounts, there’s nothing to apply to your capital gains tax bill. Wealthsimple ensures that Traditional and Roth IRA accounts held with us do not participate in tax-loss harvesting.
Another important note is our compliance with the wash sale rule. Essentially, the rule says that you are not allowed to buy back the same security that was sold in the past 30 days in any account owned by members of the same household. When Wealthsimple does tax-loss harvesting, we only know about the accounts that you have with us. Because we don’t know about your non-Wealthsimple accounts we can’t ensure compliance with the wash sale rule.