What Is Tax-Loss Harvesting?
Key Takeaways
- Tax-loss harvesting involves offsetting capital gains with capital losses so that little or no capital gains tax comes due.
- Investors might intentionally sell some securities at a loss to achieve this when they have significant gains.
- Losses can offset regular income by up to $3,000 when they exceed gains.
- Any losses over the $3,000 threshold can be carried forward into future tax years.
Definition and Example of Tax-Loss Harvesting
Tax-loss harvesting can be valuable to an individual who invests in taxable brokerage accounts, as a means of either reducing or eliminating capital gains or reducing ordinary taxable income. The strategy isn’t appropriate for tax-deferred accounts like 401(k) or IRA accounts, because the original investment and earnings already grow tax-free in those accounts.
It’s all about balancing gains with losses. A capital gain occurs when you sell a security like a mutual fund or ETF for more than its purchase price. You would incur a capital loss if you were to sell an asset for a lower price than that at which you bought it. You don’t truly realize the gain or loss on any security as a taxable event until you sell it.
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You have an unrealized gain or loss based on the security’s current value and an increase or decrease in investment value on paper before you actually sell.
You’ll owe capital gains tax if you have a gain. Long-term capital gains on securities that are held for over one year are taxed at lower rates. A maximum rate of 20% applies, but most taxpayers will pay zero in capital gains tax or a 15% rate.
You’ll have a short-term capital gain if you sell a security you’ve held for one year or less. These are taxed at higher ordinary income tax rates.
How Tax-Loss Harvesting Works
Now suppose that you invested $6,000 each in Fund A and Fund B, but Fund A is worth $7,000 now, and Fund B is worth $2,000. You would have a capital gain of $1,000 and a loss of $4,000. This would result in a net loss of $3,000. You wouldn’t owe any tax on the gain. You could also reduce your taxable income by that $3,000.
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The key to a harvesting strategy is to pay attention to the fair value of one share of the security. This is also known as the “net asset value” (NAV).
What It Means for Individual Investors
Tax-loss harvesting isn’t without its potential pitfalls:
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- Be aware of the “wash-sale” rule. Some investors like to buy back the same fund that they earlier harvested or sold, but the IRS rule surrounding wash sales stipulates that you can’t deduct the loss if you sell a security at a loss and buy a “substantially identical” security within 30 days before or after the sale. An exception applies if you incurred it in the course of doing ordinary business.
- Don’t confuse tax-loss harvesting with capital gain distributions, which are those that a mutual fund pays from its net realized long-term capital gains. You can use losses to offset these capital gains distributions, but you can’t use them to offset distributions of net realized short-term capital gains. These are treated as ordinary dividends rather than capital gains.
- A wise investor can also reduce taxes in a regular brokerage account by reducing income from dividend-paying mutual funds and taxes from capital gains distributions through a strategy called “asset location.” You can place tax-efficient investments that generate little to no income within taxable accounts.
- Tax-loss harvesting is a year-round activity. It’s often a year-end investment strategy. A savvy investor should be mindful of all fund purchases and sales throughout the year. Make investment decisions based on financial objectives, not market whims.
Do I Have to Pay Capital Gains Tax?
You’ll only pay capital gains tax on “net gains,” which are your gains minus your losses. You can use a capital loss to offset a capital gain if your gains exceed your losses. You can reduce your taxable income by the lesser of $3,000 or your total net losses if your losses exceed your gains during the tax year. You can only reduce your taxable income by up to $1,500 in losses if you’re married and file a separate tax return.
An investor can carry forward and apply any unused losses to future tax years if net losses exceed $3,000.
Taxation can be a great headache for many investors, especially those who have gathered considerable gains on the capital account. One of the common techniques available to investors for reducing their overall tax liability involves a process called tax-loss harvesting. The article describes what this practice really entails: the benefits accruing from tax-loss selling, how it works, and what this means in terms of tax planning.
Understanding Tax-Loss Harvesting
Tax-loss harvesting is a selling of securities at a loss to offset previously recognized gains, which have been subject to taxes from other investments. The losses from these sales reduce his overall tax liability because he can offset the gains with losses. This method could be very helpful while experiencing market volatility whereby some investments fall while others appreciate in value.
The concept is simple: you realize a loss in one investment, then utilize that to offset any capital gains made from other investments. Suppose that in one year, you sold stock A at a $5,000 loss and sold stock B at a gain of $7,000; you could take the loss on stock A and apply it against part of the A gain on stock B, hence reducing your taxable income and thus lowering your tax payable.
How Tax-Loss Harvesting Works
1. Losses Checking
Tax-loss harvesting first begins with the identification of investments currently running in the red. Though investors often take a keen look at their portfolios towards the end of the year, tax-loss harvesting can be done at any time. The trick lies in knowing when an asset has fallen significantly enough to sell for a loss.
2. Sale of an Investment
Once the investment is identified as a loser, the next step is to sell it. This is called “realizing” the loss. Now, it can be used for tax purposes. Keep in mind, the IRS has just one big rule concerning the realization of losses, which basically means the sale of the security must be completed in order to claim the loss.
3. Offset Gains
The losses from the sold investments can be used off against capital gains from other investments. The IRS allows the investors to offset gains with either short-term gains or with long-term gains. If, on the other hand, there occur losses in excess of the gains, as much as $3,000 may be deducted against ordinary income every tax year.
4. REPURCHASING INVESTMENTS
Many investors, in order to maintain their investment strategy, immediately or very shortly after selling securities at a loss, repurchase the same or similar securities. However, tax law provides a “wash sale” rule-the investor cannot claim a loss if he has bought or buys the same security within 30 days before or after the sale. In that case, investors sometimes purchase a similar but not identical investment within the next month because they want to remain exposed to the market, while still taking advantage of tax benefits from harvesting their losses.
Tax-Loss Harvesting Benefits
1. Minimizing Tax Liability
Most of the benefits from tax-loss harvesting come from tax liability reductions. By offsetting capital gains with losses, investors are able to lower their taxable income. This is of particular benefit in the years when big gains occur, helping investors retain more of their profit.
2. Investment Strategy Flexibility
Tax-loss harvesting can really afford an investor the opportunity to reassess their strategy. The sale of underperforming assets might lead to much greater efficiency within the portfolio and the better concentration of assets on securities that could help in achieving long-term objectives. This can give rise to a far healthier investment strategy, focused squarely on performance and potential.
3. Potential Future Gains
Through loss harvesting, investors can rebalance their portfolios towards future growth. The sale of losing investments can liberate capital to reinvest into higher-performing assets that may hold a greater potential for return. Other than the obvious tax efficiency of this strategy, it will tend to boost overall returns through time.
4. Psychological Benefits
Tax-loss harvesting can be psychologically soothing for investors, too. Both declaring and realizing one’s losses and making strategic decisions to offset those losses can provide a sense of control over one’s financial situation. The latter proactive action diminishes stress when markets become turbulent.
Considerations and Limitations
Whereas tax-loss harvesting has many advantages, its limitation and disadvantages should not be overlooked.
1. Transaction Costs
Selling and buying back securities can be costly, for example, through the payment of brokerage commissions. These might erode any potential tax benefit from loss harvesting. It is up to the investor to make sure that any advantages of tax-loss harvesting exceed these costs.
2. Difficulty
The complexity around the rules of capital gains and losses can be overwhelming. Investors have to maintain records of their transactions, realize the consequences of the wash sale rule, and then correctly report the losses on their tax returns. It is in this respect that the complexity may so easily overwhelm, especially unseasoned investors.
3. Market Timing Risks
Tax-loss harvesting is often done in a market decline for most of their investments to be perceived to be losses, which could be very costly if the market were to rebound when it regains its position so rapidly. Investors should consider the long-term implications of selling assets and whether those moves are considered in concert with the bigger investment strategy.
4. Annual Limits
The IRS permits the offset of capital gains against losses, although it restricts the amount that can be deducted against ordinary income in any one year. If an investor realizes losses over the limit of $3,000, they are allowed to carry over the rest of the losses to future years. This can be both a good situation, or it could require careful planning to optimize the deductions in those subsequent years.
Tax-loss harvesting-best practices
1. Monitoring of Portfolio on Regular Basis
It is good that an investor goes through his portfolio from time to time to weed out potential losses. Periodical review of portfolios, at the end of the tax year in particular, can give a chance for tax loss harvesting.
2. Long-Term View
However, since tax-loss harvesting is merely a short-term technique, the investor should never lose vision that their overall strategies are usually long-term. Decisions should be made in light of overall investment objectives and overall risk tolerance.
3. Consult a Tax Professional
Given the intricacies of tax laws, one would imagine that a consultation with a professional in taxation can yield gold on workable tax-loss harvesting strategies. Professionals can help investors navigate the rules and optimize their tax situations.
4. Tax-Efficient Investing
Investors can also try to minimize the effect of capital gains taxes by focusing on tax-efficient means of investing. For example, index funds and exchange-traded funds are less likely to generate as many taxable events as active funds, thereby lowering any great need to employ tax-loss harvesting.
Conclusion
Tax-loss harvesting has perhaps been among the most effective ways to reduce the investor’s tax burden and rationalize his portfolio. By realizing losses in strategic offsetting gains, investors are able to manage their situations throughout the year as regards taxes, and subsequently their investment outcome. There may be some complexities and considerations here, but the benefits accruing to an investor from tax-loss harvesting can be really great in their overall financial strategy. Like any other financial decision, this involves being better informed and keeping a close eye on your investments, at times seeking the support of professionals. In doing so, you will be in a stronger position to utilize tax-loss harvesting and navigate better in this often tricky area of taxation.