As the world of investment changes all the time, smart traders are always looking for ways to increase profits and minimize taxes. In this regard, one such strategy that has gained popularity is tax-loss harvesting.
Many taxpayers use tax-harvesting strategies to reduce their tax burden whenever the tax-saving season comes to an end. For those who are unfamiliar, this strategy entails minimizing the capital gains taxes due on lucrative assets by selling investments that are currently losing funds (i.e., investments that were purchased for a price higher than their current worth).
What is tax-loss harvesting?
Tax-loss harvesting is an investment strategy that allows you to reduce your taxable investment income by offsetting your capital gains with losses. Any capital gain on the sale of an asset is offset by a loss on the sale of another asset, which negates any taxable gain. Although tax-loss harvesting can be used with a variety of investment methods, it is especially advantageous for active traders who have short-term taxable profits and wish to minimize the tax implications, as well as high-income investors with high capital gains tax rates.
How does tax-loss harvesting work?
Tax-loss harvesting is when you sell securities for less than their cost basis, or the price you originally paid for them. This tracks losses to balance any gains from other investments, such as the sale of a business, an investment of real estate, or another significant asset. Depending on how long you retained the assets, you can adjust how much you lost compared to what you gained. Generally speaking, long-term losses of assets held for more than a year are used for balancing long-term profits, whereas short-term losses — those you owned for 12 months or less — are used first to offset short-term gains. You can then apply short-term losses to long-term profits and long-term losses to short-term gains if your losses exceed the matching strategy.
Example of tax-loss harvesting
Let’s say you own 10 different securities in your portfolio. You want to sell Stock A since it’s doing well so you can profit from your investment. But you don’t want it to result in a tax obligation. Meanwhile, the value of a few other stocks you own — stocks B, C, and D — has decreased.
First, you sell stock A for a $5,000 capital gain, for instance. Then, you sell stock B for a $1,500 loss, stock C for a $2,000 loss, and stock D for a $1,500 loss. Those losses combined equals $5,000, which is enough to offset your $5,000 gain from stock A. You are able to enjoy your large profit from stock A without paying any capital gains taxes.
You want to reinvest the proceeds from your stocks that you sold for a loss after you have completed harvesting your tax losses without going against the wash-sale rule. This can be accomplished by buying a stock that differs significantly from the ones you sold or by investing in shares in a diversified exchange-traded fund (ETF). If you think the stocks you sold will increase in value, you can also choose to wait for another 30 days to rebound.
Advantages of tax-loss harvesting
Your financial circumstances will determine the possible benefits of harvesting tax losses. Here are a few situations in which tax-loss harvesting could be advantageous.
Adjusting a portfolio to reflect an up or down market: Balance is part of the concern in an up market. In a rising market, rebalancing will result in capital gains. Therefore, the decision one has to make depends on the tax burden. It would be a good idea to rebalance in order to incur the least amount of capital gains if you have some investments with profits while others with losses. Perhaps you have some positions with gains.
Staying in a lower tax bracket: Continuing to pay less in taxes. Investors who are about to enter a tax bracket can opt to accept a loss in order to lower their adjusted gross income (AGI) and remain in the lower tax bracket. You could be able to qualify for additional deductions.
If you own substantial assets: Those with extremely high and very high net worths are used to considering capital gains and losses. They frequently own a variety of assets, including companies, investments and a portfolio of properties they could potentially sell. Harvesting tax losses could be crucial to balance profits.
If you are getting close to retiring: Combining net unrealized appreciation (NUA) planning with tax-loss harvesting can be a useful tax-saving strategy if you have a significant amount of company shares in your retirement plan. “You can identify other stock positions in your taxable account that have experienced significant losses that you want to sell and use the realized capital losses to offset some of the realized capital gain on the subsequent sale of some of your company stock.
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Tax-loss harvesting and ordinary income
Tax loss harvesting is beneficial even for those who do not declare capital gains, even though investment losses are frequently utilized to lower capital gains taxes. This is done so that taxes on your regular income can be offset by investment losses. Married couples filing jointly and single filers can deduct up to $3,000 in realized losses from their regular income. Each spouse filing separately is entitled to a $1,500 regular income deduction. If your realized losses exceed $3,000, you can be able to carry over the excess losses in increments of $3,000 into subsequent tax years.
Remember that in order to offset cap gains of the same kind, you must first employ capital losses on investments. Long-term losses must be subtracted from long-term profits, and short-term losses must be applied first against short-term gains. Any remaining losses of either kind cannot then be applied to balance the other kind of gain. Indeed, but there are limitations. Capital gains of the same kind are first offset by losses on your investments. Hence, long-term losses are subtracted from long-term profits, and short-term losses are subtracted from short-term gains first. Any form of net loss can then be subtracted from the other type of gain. If you still have net losses after that, you can deduct those remaining net losses from your regular income, such as salary and pension income.
When to use tax-loss harvesting
Here are some pointers which you need to keep in mind when considering to use tax-loss harvesting:
Market conditions: Tax-loss harvesting can be used in any situation, but it can be especially helpful in a down market. Not only are you more likely to have assets in your portfolio that are losing value, but you can also buy them back at a discount because you know they will probably rise in value. Remember the wash-sale policy.
Tax bracket considerations: Your capital gains tax rate is significantly influenced by your tax bracket. You will have to pay more in capital gains taxes if you have significantly higher income. Therefore, tax-loss harvesting is more advantageous the higher your taxable income and tax bracket. However, individuals with taxable incomes low enough to qualify for the 0 percent capital gains bracket do not benefit from tax-loss harvesting.
Account type: Not all investment accounts require tax-loss harvesting. Investing in an individual retirement account (IRA) or other tax-advantaged retirement account already prevents you from paying taxes on your capital gains and losses. Therefore, you only need to use this method when investing in a taxable broking account.
Who should use tax-loss harvesting
Tax-loss harvesting is not suitable for every person or situation. As a strategy, it makes ideal assumptions about variables that are frequently rather unpredictable in the real world. Delaying tax payments, for instance, is only effective if tax rates stay the same or decrease for both individual taxpayers and capital gains. However, tax rates are unpredictable in the real world, particularly when considering the duration of the majority of investment portfolios. The taxpayer may end up with a future tax obligation that is far larger than any gains from reinvested tax savings if tax-loss harvesting backfires.
Conclusion
Tax optimization is a vital concept that falls under the larger category of financial planning. It contributes significantly to your financial well-being. One method to minimize your tax burden is to use tax-loss harvesting, which lowers your capital gains by balancing them with losses.
Frequently Asked Questions (FAQs)
Is tax-loss harvesting risky?
Tax-loss harvesting is not risky as it does not involve any loss-making investment. On the contrary, it involves selling the already loss-making assets and setting off the losses against the profits to reduce the capital gains tax liability.
What is the wash sale rule?
As per the wash sale rule, any asset that is sold at a loss and then repurchased within 30 days of sale cannot be offset against any profits or used for any other tax-related purposes. Therefore, taxpayers are required to wait 30 days after selling the asset to repurchase any other asset, either similar or different in nature.
What are the rules for tax-loss harvesting?
The tax-loss harvesting process involves three steps. First, selling securities that have decreased in value. Second, utilizing the capital loss to counterbalance capital gains from other sales. Third, substituting the sold investments with similar investments to uphold the preferred investment exposure.
How can I determine which investments are good for tax-loss harvesting?
An investment must have negative returns to be a strong candidate for tax-loss harvesting. The potential cost of tax-loss harvesting as a result of the wash-sale regulation is another consideration. Investors should think about whether they would be OK missing out on the following 30 days of possible profits after selling, as they cannot harvest losses on an investment that you repurchased within 30 days of selling.
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