For professionals who receive equity compensation, stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPPs) can be significant sources of wealth. However, they also come with unique challenges, including volatile stock prices. When markets decline, these fluctuations can lead to unrealized losses in your portfolio. Fortunately, there is a silver lining: tax loss harvesting.

Tax-loss harvesting is a strategy that allows you to turn investment losses into tax savings, offsetting taxable income or gains and potentially improving your financial position. In this post, we’ll explore how tax-loss harvesting works, why it’s particularly useful for professionals with stock compensation, and how you can implement it effectively.

 

Tax Loss Harvesting Explained: How It Works and Key Benefits

Tax-loss harvesting is the process of selling investments at a loss to offset capital gains and, in some cases, reduce taxable income.

Here’s how it works:

Offset Capital Gains 

Realized losses can be used to offset realized capital gains on other investments. If your losses exceed your gains, up to $3,000 of the remaining loss can be deducted against your ordinary income each year.

 

Carry Forward Excess Capital Gains Losses

If your losses exceed the $3,000 annual deduction limit, the excess can be carried forward to future tax years to offset gains or income later.

 

Reinvest Proceeds

To maintain your portfolio’s desired allocation, you can reinvest the proceeds from the sale into similar, but not identical, investments. Be mindful of the IRS’s wash-sale rule, which prohibits you from repurchasing the same or substantially identical security within 30 days before or after the sale.

 

Why Tax-Loss Harvesting Is Valuable for Professionals with Equity Compensation

Professionals who receive equity compensation often have concentrated positions in their company’s stock, which makes them particularly susceptible to market volatility.

 

Here’s why tax-loss harvesting can be especially beneficial:

 

Offset Taxable Gains from Equity Compensation 

Many professionals face significant tax obligations when they sell RSUs, exercise stock options, or participate in ESPPs. If other investments in your portfolio have declined in value, tax-loss harvesting can help offset the gains from your equity compensation, reducing your overall tax bill.

 

Manage Concentrated Stock Risk 

Holding too much of your wealth in a single company’s stock can be risky. When the stock declines, tax-loss harvesting provides an opportunity to reduce exposure while gaining a tax benefit. By reinvesting the proceeds into a diversified portfolio, you can balance risk without missing out on potential market recovery.

 

Improve Cash Flow 

By reducing your taxable income, tax-loss harvesting can lower your tax liability and improve cash flow. This extra cash can be reinvested, saved, or used to meet other financial goals.

 

How to Implement Tax-Loss Harvesting

Implementing tax-loss harvesting effectively requires careful planning and a solid understanding of tax rules. Here are the steps to follow:

Step 1: Identify Losses

Review your portfolio to identify investments that are trading below your purchase price. Focus on securities where the losses are substantial enough to provide meaningful tax benefits.

Step 2: Check for Wash-Sale Rules

Avoid triggering the IRS’s wash-sale rule, which disallows tax benefits if you repurchase the same or substantially identical security within 30 days. Instead, reinvest in a different security or an ETF that provides similar exposure.

Step 3: Time Your Tax Harvesting

Consider harvesting losses strategically throughout the year, particularly when you’ve realized significant gains from stock sales or equity exercises. Tax-loss harvesting can be particularly useful in years when equity markets are volatile.

Step 4: Consult a Financial Advisor or Tax Professional 

Tax-loss harvesting can become complex, especially if you have multiple forms of equity compensation. A professional can help you navigate the tax implications, avoid pitfalls, and integrate this strategy into your broader financial plan.

 

Stock Loss Tax Deduction: A Real-Life Example for Professionals with Equity Compensation

 

Let’s say you exercised stock options earlier this year, realizing a $50,000 gain. In the same year, you have $20,000 in unrealized losses from other investments due to market volatility. By selling these underperforming assets, you can offset $20,000 of the $50,000 gain, reducing your taxable income and saving on taxes. If you’re in a 32% federal tax bracket, this could save you $6,400 in taxes—a significant benefit.

 

Key Considerations and Risks of Tax Harvesting

1. Long-Term Investment Goals: Ensure that tax-loss harvesting aligns with your broader financial objectives. Can short-term tax benefits offset long term gains? Yes, but there are definitely limitations to this strategy. Avoid making decisions solely for short-term tax benefits. 
2. Transaction Costs: Frequent buying and selling of securities can result in transaction fees, which may erode the benefits of tax harvesting.
3. Market Recovery: Selling an asset locks in the loss, meaning you could miss out on a potential recovery if you don’t reinvest wisely.
4. State Taxes: Remember to consider state tax implications, as these vary and can impact the overall effectiveness of tax-loss harvesting.

Implementing Tax-Loss Harvesting Strategically

Tax-loss harvesting is a powerful, yet often overlooked, strategy for professionals navigating the ups and downs of equity compensation and volatile markets. By using this approach, you can reduce your tax liability, offset gains, and improve cash flow—all while maintaining a well-diversified portfolio.

If you’re unsure how to implement tax-loss harvesting or want guidance on managing your equity compensation, consider working with a wealth management advisor who understands the unique financial challenges of stock options. With the right strategies in place, you can take control of your taxes and maximize your wealth-building potential.