Tax loss harvesting is a strategy that uses investment losses to create tax savings. The idea is to purposely sell investments that have gone down in value so that you lose money on your investments, in order to save money on your taxes. It's something we do automatically for Wealthsimple Black clients, but all clients have the option of using tax loss harvesting. It's important to know that tax loss harvesting only makes sense in certain circumstances. It's a little complicated, so you may want to read up on our Investing 101 page.
When Tax Loss Harvesting doesn't make sense
To understand why tax loss harvesting doesn't always make sense, let's pretend you're a Wealthsimple client and when you start investing you:
- Are a New York state resident
- Have an annual taxable income of $80,000
- Invest $90,000 in an Individual (taxable) account and deposit $16,000 each year
The first year, Wealthsimple's automated system harvests (sells off to buy something similar at a lower price) $6,000 worth of losses from your portfolio. Each year, the losses harvested from your portfolio grow in proportion to your portfolio size.
Each year, your income grows by 7% and the market returns 5% on your investment. After 15 years, you decide to sell your portfolio. Now:
- Your annual income is a little over $210,000 (putting you in a higher tax bracket)
- Your portfolio has grown to be worth $523,108
- You've deposited $314,000 (your $90,000 initial deposit + $16,000 each year for the next 14 years)
- You have harvested a total of $271,899 over the past 15 years ($6,000 in first year, and more each year after that as your portfolio grew, e.g one fifteenth of the portfolio each year)
- The cost of your investment - how much you bought it for - is $42,101 ($314,000 in deposits -$271,899 in tax loss harvesting)
When you pay taxes on your investment gains, you're paying the difference between what your portfolio is worth and what you bought if for. So now, instead of paying taxes on the value of your portfolio (remember, it's gone up each year) minus $314,000, you have to pay taxes on your portfolio minus $42,101.
So you're paying taxes on $271,899 of additional gains. And since your income has increased, you'll be paying a higher capital gains tax rate than you would have at $80,000 of income.
On the upside, since you've gotten to defer taxes rather than pay them on the spot it means you've gotten to keep those funds invested and have benefitted from the magic of compounding. That's the whole benefit of tax loss harvesting. At 2017 tax rates, you would have benefitted to the tune of $81,745 by using tax loss harvesting. But, the taxes you would have to pay would amount to $83,337 - leaving you about $1,592 poorer than if you hadn't employed tax loss harvesting.
Ok, so when should I use tax loss harvesting?
Tax loss harvesting is generally the right strategy for your portfolio if:
- Your annual income is above $100,000
- You don't plan on making a large withdrawal in the next 12 months
- You're invested in a non-registered account
If you're not sure if tax loss harvesting is the right strategy for your portfolio, get in touch and one of our experienced portfolio managers will help you figure it out.