Outside the Box: Can I use tax-loss harvesting to offset my required IRA withdrawal?

Q: I keep hearing people talk about tax-loss harvesting. How does it work and can I use losses to offset my required IRA withdrawal?

— Larry

A.: Larry, tax-loss harvesting works great for some and not so much for others. The technique can offset some ordinary income like IRA distributions but only up to $3,000 year. Keep in mind that due to the CARES Act, you don’t have to take a Required Minimum Distribution in 2020.

When markets drop, a popular thing to do is sell losing holdings in nonretirement accounts to generate capital losses. You turn a paper loss into an actual loss. This tax motivated selling is often referred to as tax-loss harvesting. It is something we consider but there are several situations where the value is minimal.

For instance, not all losses reduce taxes. Some losses aren’t usable at all and in some cases, the process of harvesting the losses can increase future taxes that exceed what was saved on the front end.

Say, you buy “A” for $50,000 and A drops 20%. You may opt to “harvest” the loss by selling A. You have probably heard that selling when markets decline is usually not wise. That has been true in the past of diversified holdings like a good mutual fund. If you are hesitant to sell such a holding, you can harvest the loss via a swap.

With a swap, you would sell fund A for $40,000 and immediately buy another similar fund with that $40,000. I’ll call the new fund “B”. Because fund B and fund A are similar, your basic investment plan is intact, but you have a $10,000 “realized” loss for tax purposes.

A swap is also a good way to avoid a wash sale which would disallow the loss. Wash sales are created when you buy shares of a holding within 30 days before or after the date you sold the same holding for a loss. The loss does not necessarily go to waste but is not available for use as I am about to describe.

Tax law dictates that the loss first be used to offset capital gains. The loss will not be of any benefit for some taxpayers. Those taxpayers whose taxable income is in the 12% marginal bracket or lower do not pay taxes on capital gains. If such a taxpayer had a $10,000 gain, the loss is used first to offset the gain but the gain was not going to be taxable anyway so the loss essentially goes to waste.

Now if a loss exceeds the year’s gains, you can use up to $3,000 against your ordinary income on your current year 1040. The value of that depends on your marginal tax bracket. In the example in the last paragraph, if that taxpayer had no gains and harvested the $10,000 loss, their ordinary income would be reduced by $3,000 saving them $360. They would then “carry forward” $7,000 of losses to the following year.

Back to our swap of A to B. After the swap, you also now own B with a basis of $40,000. If B appreciates to $50,000 and is sold, you incur a $10,000 gain. If the gain is not offset by losses or loss carryforwards, the gain is taxed at the then prevailing capital gain rate. If the rate then is high enough, the swap can cause more taxes than it saved.

Real life isn’t as simple as this example. Most people have several holdings and multiple tax lots. Often, people face multiple possible tax rates through their investment time horizon. All this means multiple planning opportunities, or pitfalls.

Tax-loss harvesting is often presented as a short-term tactical decision but really it should be considered as part of a long term strategic plan. In general, the higher your current bracket relative to your anticipated future bracket, the more likely the tax-loss harvesting tactic will pay off.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.

Dan Moisand is a financial planner with Moisand Fitzgerald Tamayo. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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