Tax-loss harvesting is a tool used by investors to reduce their overall tax liability by offsetting realized capital gains with the losses from the sale of certain investments. By offsetting these losses against capital gains, investors can reduce the amount of taxes they owe.
Tax-loss harvesting has become increasingly popular in recent years, due to the fact that it enables investors to strategically control their tax liability and take advantage of tax breaks.
For example, if an investor has made gains from investments in the previous year, they can use tax-loss harvesting to offset those gains and receive a lower tax burden.
The strategy employed by tax-loss harvesting is based on the realization of a loss in the current year in order to offset any taxable gains in the following year. This can be beneficial for investors in both the present and future.
By realizing losses in the current year, investors can reduce their overall tax burden in the following year. In addition, any losses realized can be carried forward to future years and applied against any taxable gains in those years.
After a rough year on the stock and bond markets, many investors are likely to be sitting on investment losses. Tax-loss harvesting lets you realize those losses and get a tax break for doing so. This lets you lower your taxable income or offset gains in other parts of your portfolio.
Here’s how to get the most out of tax-loss harvesting and what to watch out for so you don’t break the rules set by the Internal Revenue Service (IRS).
What Is Tax-Loss Harvesting?
Tax-loss harvesting is when you write off the losses on your investments so you can get a tax break on your regular income. To claim a loss on your taxes for the current year, you must sell investments in taxable accounts before the end of the calendar year and then report the sale when you file your taxes.
The IRS lets you claim a net loss from failed investments of up to $3,000 per year (single filers and married filing jointly), and it’s usually a good idea to do so. At the federal level, that $3,000 net loss could save you $720 in taxes if you are in the highest tax bracket of 24%. It could also save you money at the state level.
A write-off reduces any other capital gains you made during the tax year, and it’s important to remember that the deduction is a “net” loss. For example, you can make $5,000 on one investment and lose $8,000 on another and still claim the maximum $3,000 deduction.
And what if your losses are more than $3,000? The IRS lets you put those extra losses on your taxes for the next year. So, if your investments do well next year and you make some capital gains, you can use losses from the past to cancel out those gains.
Tax-loss harvesting is only useful in taxable accounts, not in special tax-advantaged accounts like IRAs and 401(k)s, where capital gains aren’t taxed every year (or sometimes at all – in the case of the Roth IRA.)
How To Take Advantage Of Tax-Loss Harvesting
Follow the steps below if you want to get the most out of tax-loss harvesting. At the end of the year, it helps to be very organized so you know how much you need to sell to make the strategy work best.
Set Your Goal
Do you just want to cancel out your gains and make a net loss of $3,000? Or do you want to get out of a losing position and don’t care if your write-off isn’t perfect?
If it’s the first, you might want to keep your money in a position that is losing money but has a good future.
If the second is true, you might not care how much you’ve made this year.
If you don’t want to tweak your write-off, you can just sell your losers or any other investment you don’t believe in anymore and move on. You can separate your gains and losses when it’s time to figure out your taxes.
Determine Your Gains And Losses
But if you want to fine-tune your loss and stay as invested as possible, you should figure out your realized gains for this year and anything else you might sell by the end of the year. Then you can figure out how much you need to lose to cancel out those gains.
Check your brokerage statements to see which of your investments are losing money.
Make The Transactions
Once you know how much you need to sell and which positions you want to sell, you should make the trades in your brokerage account before the end of the year.
The wash-sale rule says that you can’t buy back into the position for at least 30 days after taking a loss on it.
Many Robo-Advisors Automate This Process
Getting the most tax break out of your capital losses can take some extra work, but investors should still do it because it makes a lot of sense.
But if you use a robo-advisor to manage your accounts, you can usually get tax-loss harvesting at no extra cost. Robo-advisors offer a lot of benefits for a price that may surprise you.
Tax-loss harvesting can be sped up by robo-advisors, which can do more than most human advisors could. For instance, robo-advisors use an automated process to help you save the most on taxes, and they may check every day to see if they can make a loss on any fund. Then, the robo-advisor buys a similar but different fund that mimics the performance of the first one. This gives you a tax break while still giving you a fund that is likely to do as well.
This is one of the best things about a robo-advisor, and many of them also offer automatic rebalancing.
Beware Aware Of These Things When Tax-Loss Harvesting
Here are three things you should watch out for when taking advantage of this tax break.
Wash Sales
Tax-loss harvesting does have some rules put in place by the IRS to make sure you don’t try to get around the rules. The “wash-sale rule” is the most important of these restrictions. It says that you can’t claim a taxable loss and then buy the security back right away. Even if you are married, you can’t sell and claim a loss while your partner buys in their own account.
If you want to report a loss on your taxes, you and your spouse must wait at least 30 days before buying the losing security again. If you buy the same security again within 30 days, you have to give up the tax advantage. You won’t lose the tax benefit for good, though. When you do sell the security again, you can get the tax benefit back and write off the loss.
Short-Term Vs. Long-Term Losses
The IRS makes it clear that you have to do this. That is, your long-term capital losses offset your long-term capital gains first, while your short-term capital losses offset your short-term capital gains first. I
t’s important to know the difference because the tax you pay on capital gains depends on how long you’ve owned the security. You can only make up for short-term gains with long-term losses after you’ve added up all your results.
Long-term capital gains are taxed at special rates that can be lower than what you would pay on your regular income. Depending on your income, these rates are 0, 15, or 20%. These rates are for things you’ve owned for more than a year.
Your ordinary income tax rate, which can be as high as 37%, is applied to short-term capital gains. These rates are for things you’ve owned for less than a year.
Don’t Just Sell To Get A Tax Break
It’s easy to sell an asset like a stock just to get a tax break, which is a sure thing, even though the future gain on the stock is not a sure thing. This is especially true because stocks can change a lot over a short period of time.
But if you’re keeping the stock for its long-term potential and not just for this tax year, you might want to think twice about whether it’s smart to sell for a capital loss.
Stocks are investments that usually do well over time, and claiming a loss now could mean selling the stock just as it’s about to go up again. If there’s nothing wrong with the investment at its core, you might want to keep it instead of selling it.
Is Tax-Loss Harvesting Worth It?
By taking advantage of investment losses, tax-loss harvesting is a way to save money on taxes right now. Those who go through the process save real money on taxes, but there are times when realizing losses is a mistake.
For example, an investment can sometimes take a short-term loss on its way to making huge gains. There is a thin line between selling because you didn’t wait long enough and selling because you made a mistake in your analysis.
Think about how the investment will do in the long run and if anything has changed since you bought it. If you still think the investment has potential, you might do better to keep it.
Bottom Line
Tax-loss harvesting lets you get a tax break on a bad investment, and it’s a good way to cancel out other taxable gains, especially if you don’t think the investment will ever do well again.
If you want to lower your tax bill in any given year, you might want to take advantage of everything you can.
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