The primary goal of Tax-Loss Harvesting (TLH) is to sell an investment at a loss in order to offset any gains and/or to reduce income. Then, a “substitute” security is usually purchased (one that is not substantially identical to the one with the loss) for the next 31 days (wash-sale period) so as not to be out of the market. After the wash-sale period, the substitute security can be sold and the original security repurchased. This process creates a so-called “tax savings” that can either be re-invested (i.e., tax savings generated from a net capital loss) or simply remain invested (i.e., tax not owed on a gain because it was offset by an equal loss).

Tax savings is not present in all situations, so please consider the following risks before TLH:

Future Tax Rates: I don’t really consider this a risk, but others do, so I thought I would address it. The theory is that you could lose wealth if you TLH at today’s tax rates and you expect your future tax rate to be higher. It’s important to note that this risk is only present when you have unavoidable gains (i.e., mutual fund capital gain distributions), but is not present at all if you face avoidable gains (see below). When you have unavoidable gains, your wealth will reduce if you TLH today with your tax bracket rising in the future; however, the end result will likely still be better than not TLH at all.

Avoidable Capital Gains: These are gains that you choose to incur by selling an appreciated asset. However, there are no tax savings when you voluntarily incur a gain just to harvest a loss. Reason being is that the cost basis and net future value will be the exact same regardless of whether you TLH or not. In this situation, it’s almost always better to just harvest the losses and not realize the gains.

Transaction Costs: I consider this to be a relatively minimal risk especially with the amount of low cost assets out there. Just be careful to not TLH too much and watch out for smaller accounts whereby transaction costs would represent a large percentage of the total account.

Tracking Error: This, in my opinion, is the GREATEST RISK of them all. The substitute security owned during the wash-sale period (or even beyond) may not perform as well as the original. History shows that market gains come very quickly and unexpectedly, so being out of the market with your original investment could prove detrimental. Don’t let the tax tail wag the investment dog. The goal is to make money!! Additionally, tracking error is unknown until after the fact. And by then it may be too late.

Short Term Capital Gains: If your substitute security goes up during the wash-sale period and you “switch back” to the original investment, a short term capital gain would be incurred possibly wiping out the TLH benefit.

Long-Term Gains Converted to Short-Term Gains: I won’t get into the details here, but based on the way the IRS ordering rules work when calculating gains and losses, a gain intended to be long term could be forced into being a short-term gain when switching from a substitute security back to the original investment.

Rebalancing: Rebalancing is intended to sell the winners and buy the losers. However, with TLH, the intent is to sell the losers. Seems like this could pose a conflict between asset allocation and tax efficiency. This is especially true since you wouldn’t be able to rebalance and bring the losing asset up to its target percentage or you would violate the wash sale rule. In fairness, you could sell an investment at a loss and then rebuy enough of a substitute security to rebalance the portfolio or you could simply rebalance your original securities after the wash-sale period. But this comes with the risk of having a potentially less than ideal security or portfolio during the wash-sale period.

Low Tax Bracket: DO NOT TLH when in the 15 percent or less tax bracket because any gains would be taxed at 0 percent anyway! You would unnecessarily lower the cost basis, which would result in a larger gains tax in the future. A better strategy would be to harvest the gains instead.

Although TLH is sold by many as a way to increase alpha, I believe the jury is still out on that. As you can see there are numerous risks present reflecting that TLH is not always a slam dunk.

Brad Tinnon, CFP, is the owner of Best Wealth Management.