Taxes August 26, 2016

    When you sell investments that have increased in value, you typically have to pay taxes on those earnings—15% or 20% for assets held more than a year (depending on your income level) or your marginal income tax rate for assets held a year or less. Depending on the amount of appreciation, you could be hit with a large tax bill when April comes around.

    One way to help reduce current capital gains taxes is to generate capital losses—which are tax-deductible—in order to offset some or all of those gains. This strategy, called tax-loss harvesting, can potentially help defer current tax liabilities when deployed correctly.1

    How tax-loss harvesting works

    Selling securities at a loss in order to offset capital gains can be a smart strategy.

    Figure 1: Tax-loss harvesting can help reduce current tax liabilities

    Tax-loss harvesting can help reduce current tax liabilities

    Once you've harvested your losses, you'll need to replace those assets to keep your portfolio allocation on target. Enter the IRS's "wash sale" rule.

    What is a wash sale?

    A wash sale occurs when you sell a security at a loss and then you, your spouse or your IRA purchases the same security—or one that is "substantially identical"—within 30 calendar days before or after the sale. If this happens, the IRS will disallow any tax deductions resulting from the loss. The theory behind the rule is this: By selling a security for a loss and then buying it (or a substantially similar security) right back, you haven't actually incurred a loss and therefore shouldn't be allowed a tax break.

    Unfortunately, the IRS doesn't provide hard-and-fast guidance on what constitutes a substantially identical security, which makes it difficult to know whether or not you're running afoul of the rule.

    What are the consequences of a wash sale?

    First and foremost, you won't be able to claim a loss on the sale of your depreciated assets. Instead, your loss will be added to the cost basis of the replacement purchase, to be recognized when you sell the replacement security at some future date. If you don't sell the replacement security for a loss in the same year as your capital gains, you'll miss out on the tax-loss harvesting benefits.

    It's also possible to trigger a wash sale inadvertently. The most common way to do so is by selling a portion of a dividend-paying security within 30 days of a dividend distribution date. If dividends are set to be reinvested, even the smallest reinvestment will trigger a wash sale and disallow your losses.

    How can you avoid triggering a wash sale?

    Consider these three tips to help you steer clear of the wash-sale rule:

    1. Research replacement securities: The IRS website does provide some guidance about what constitutes a substantially identical stock, but its guidance is murkier for mutual funds and exchange-traded funds. Be sure to conduct thorough due diligence before purchasing a replacement security, and consult a financial professional if you need help assessing your investments.
    2. Know your dividend dates: If you're not selling all of your shares of a single security, make sure to time the sale so that dividend reinvestments don't compromise your capital losses.
    3. Leave it to the pros: Consider enrolling in a portfolio management solution that offers tax-loss harvesting and wash-sale monitoring, like Schwab Intelligent Portfolios®.

    How Schwab Intelligent Portfolios handles wash sales

    Schwab Intelligent Portfolios offers automated tax-loss harvesting for taxable accounts of at least $50,000. For clients who enroll in the service, portfolios are automatically monitored and trades are executed when an ETF in any asset class sees price movement large enough to warrant a sale to capture the loss. Proceeds from the sale are then reinvested in an alternate ETF in the asset class to maintain the portfolio's targeted asset allocation. Schwab Intelligent Portfolios seeks to capture tax-deductible capital losses, while monitoring linked Schwab Intelligent Portfolios accounts (but not other Schwab accounts or accounts held outside Schwab) in order to avoid triggering a wash sale.

    Schwab Intelligent Portfolios seeks to avoid wash sales by selecting two ETFs for each asset class that track different underlying indexes. For example, the primary U.S. large-cap stock ETF selected is the Schwab U.S. Large-Cap ETF (SCHX), which tracks the Dow Jones U.S. Large-Cap Total Stock Market Index. The alternate U.S. large-cap stock ETF selected is the Vanguard S&P 500 Index Fund (VOO), which tracks the S&P 500 Index. The tax-loss harvesting activity within an account depends on market conditions, when an account is opened, subsequent deposits/withdrawals, whether portfolios are switched after opening the account and other factors.

    Did You Know?

    The Schwab Intelligent Portfolios site includes informative white papers, where you can read more about our ETF selection process and tax-loss harvesting algorithm.

    1. A loss and subsequent repurchase at lower market levels lowers your portfolio's overall cost basis, so the taxes are actually deferred. The benefit of the strategy lies with the time value of money and your ability to invest current tax savings for additional future growth. Permanent savings may be realized if short-term gains become long-term or if the shares are gifted or bequeathed.

    The tax-loss harvesting feature that is available with Schwab Intelligent Portfolios is subject to significant limitations which are described on the Schwab Intelligent Portfolios website and mobile application (collectively, the "Website") as well as in the Charles Schwab & Co., Inc. (“Schwab”) Schwab Intelligent Portfolios disclosure brochures (the "Brochure"), and the IRS website at www.irs.gov in light of your particular circumstances and its impact on your tax return. You should consider whether or not to enroll in tax-loss harvesting based on your particular circumstances and the potential impact tax-loss harvesting may have on your tax return.

    You should read the tax-loss harvesting disclosures on the Website and in the Brochure before choosing the tax-loss harvesting feature if you decide to enroll in Schwab Intelligent Portfolios. Neither the tax-loss harvesting strategy for the Schwab Intelligent Portfolios program, nor any discussion here in is intended as tax advice, and neither Schwab or its affiliates, including but not limited to Charles Schwab Investment Advisory, Inc. represents that any particular tax consequences will be obtained.

    (0119-8G1Z)


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