What Is Tax-Loss Harvesting?
Imagine that on the first day of any given year, you invest $100,000 in the U.S. stock market via an exchange-traded fund (ETF), like S&P depositary receipts (SPDR). Let's assume this ETF trades off by 10%, falling to a market value of $90,000. Rather than feeling sorry for yourself, you can sell the ETF and reinvest the $90,000 back into the stock market.
Although you are keeping your market exposure constant, for IRS tax purposes, you just realized a loss of $10,000. You can use this loss to offset taxable income - leading to incremental tax savings or a bigger refund. Since you kept your market exposure constant, there really hasn't been a change in your investment cash flow, just a potential cash benefit on the tax return. (Read more about SPDRs in What is a spider and why should I buy one?)
Now let's say that the market reverses course and heads north, surpassing your initial investment of $100,000 and closing out the year at $108,000, yielding the average 10% pretax return when adding a typical 2% dividend yield. For ease of calculation, let us assume that your marginal tax rate is 50%. Had you done nothing except buy-and-hold in the aforementioned scenario, you would have an after-tax return of 9%, represented by an 8% unrealized investment gain plus a 1% dividend gain (2% dividend less 1% paid in tax to the government due to a 50% marginal tax rate).
Read more: http://www.investopedia.com/articles/taxes/08/tax-loss-harvesting.asp#ixzz1bIb8NwRh
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