Everyone is excited to sell investments while the market is high. There is money to be made in the old adage of “Buy Low and Sell High,” right? Yes, but there are also taxes to be paid on any profit that you make.
Tax loss harvesting, sometimes called tax loss selling, is a way to help minimize taxes that are owed, but not everyone does it. Why not? Most people don’t fully understand tax loss harvesting and how to make the best use of it.
Let’s take a deeper look.
What is Tax Loss Harvesting?
Tax loss harvesting is a term used to describe selling unprofitable investments. The loss can then be claimed on your taxes and can offset any profit you made with other investments. It is an important tool to reduce the overall amount of taxes paid.
To understand this better, let’s first take a look at capital gains.
If you have investments such as bonds, jewelry, real estate, or stocks, you most likely are familiar with the concept of profit, also called capital gains. This does not apply to retirement accounts or other investment accounts like a 401(k) or IRAs because you don’t draw from these until you retire.
There are two types of capital gains:
● Realized. If an investment has increased in value and you sell it for a profit, this is considered “realized” capital gains.
● Unrealized. When your investment has increased in value and you have not sold it yet, it is “unrealized” capital gains.
Capital gains tax is levied by the government when you sell an investment asset and make profits, or capital gains, from it. In other words, when you have “realized” capital gains, you must pay the government tax on it. How long you have had the investment determines how it is taxed.
What’s the difference?
● Short-term Capital Gains. If you have bought and sold the assets in one year or less, this is short-term capital gains. The profit you make is considered ordinary income and taxed at your income tax rate, which may be as high as 37%.
● Long-term Capital Gains. When you sell assets that you have held longer than one year, it is considered long-term capital gains. The tax owed is different and may be 0%, 15%, or 20%, depending on your tax bracket.
Usually, long-term capital gains are taxed at a lower rate than short-term capital gains. You can lessen the tax you pay on any capital gains simply by holding on to your assets longer than one year.
Another strategy to lessen taxes owed: tax loss harvesting.
Benefits of Tax Loss Harvesting
Knowing the right time to pursue tax loss harvesting will lead to the best outcome from it. How do you know if tax loss harvesting would be beneficial to you? Some considerations include:
High tax bracket. If you are in a high tax bracket, you will potentially benefit more than someone who is in a lower one. The main idea is to lower taxes, so if you are already in a low tax bracket, tax loss harvesting may not help as much.
Individual Stocks and ETFs. Tax loss harvesting is easier if your investments are in individual stocks and ETFs (also known as exchange-traded funds) rather than mutual funds or index funds (which can be trickier).
Bad Investment Year. If you have had capital losses this year, it might be a good year for tax loss harvesting. You can claim up to $3,000 per year in losses. If your losses exceed that, you can carry over any extra into the next tax year.
How It Helps You
It seems counterintuitive that selling investments for less than what you paid for them will benefit you. But with tax loss harvesting, you can take advantage of investment losses and put them to work for you. Some benefits include:
● Lowered Taxes. We’ve mentioned this several times. But how does it actually play out? Let’s look at a simple example: Stock A sold, realized long-term capital gains of $10,000. Stock B sold, realized long-term capital loss of $5,000. Let’s use a tax rate of 20%.
○ Without tax loss harvesting: $10,000 x 20% = $2,000 tax owed
○ With tax loss harvesting: ($10,000 - $5,000) x 20% = $1,000 tax owed
The loss offsets the amount of taxes owed on the gains.
● Preserving Portfolio Balance. Even though you sell an investment at a loss, you can use the money you make to buy other investments. Essentially you are dumping the losers and replacing them.
○ Rebalancing. You can purchase an investment to rebalance your portfolio or round it out with an asset that you currently lack. When you rebalance your portfolio, you are realigning your assets in regards to returns and risks.
○ The Caveat. Whatever you purchase can’t be the same or similar investment. The IRS has a “Wash-Sale” Rule that prohibits investors from selling and purchasing the identical or “substantially similar” stock or security within 30 days of selling the old one. If this happens, you cannot take the loss as a tax credit and it was all for naught.
How often should you be using tax loss harvesting? Every time the stock market dips? Whenever you experience a loss? Some like to use it throughout the year while others wait until the end of the calendar year. It really depends on several factors.
Starting a conversation with a financial advisor is the first step in understanding and employing tax loss harvesting for maximum benefit to you.
Written by Matthew Delaney