I’m sure you have seen articles touting the benefits of tax-loss harvesting. What exactly is tax-loss harvesting? Well, at a very basic level, it’s selling a security at a loss to offset a gain; usually, to limit the recognition of a short-term gain which is taxed at higher ordinary income tax rates. The idea is to take a loss on a security and put it to work offsetting a capital gain in another area. Note that both sales, the one generating the loss, and the one generating the gain, have to take place and be completed. You need to actually sell the assets involved to have recognized the loss or the gain.
It’s time to harvest because a lot of this selling occurs near year end. It doesn’t have to, though. You can tax-loss harvest any time of the year. However, it’s become common for many folks to look at their various gains over the year and to focus on their losers and see what, if anything, is available to sell to offset realized gains. Many robo-advisors do this on an on-going basis if the client selects that option.
When possible, you want the loss amount to exceed the gain amount. Why? Let’s look at an example where you, the investor, sold a stock and realized a $10,000 gain. You held this stock for only nine months. That means, the realized gain should be taxed at your ordinary income tax rate. Assume further you have another short-term investment that has lost $15,000. You sell it was well. You have realized the gain of $10,000 and the loss of $15,000. You can now apply $10,000 of the $15,000 loss against the $10,000 gain, thus eliminating the higher, short-term (ordinary) income tax rate. Here’s the bonus… you get to keep the remaining $5,000 loss and apply $3,000 of it to ordinary income tax for the year, and carry forward the remaining $2,000 to use against future tax year’s income.
A few tips to keep in mind.
In general, losses and gains are matched, or netted, against like-kind first. That is, short-term against short-term, and long-term against long-term. Excess losses from a particular gain type are then applied to either type of gain.
You should exercise caution in buying the replacement investment for the security sold at a loss. If the investment you purchase within 30 days (before or after) to replace the investment sold for the loss is the same or “substantially identical,” you will violate the “wash rule” and the IRS will disallow the deduction. Exercise caution.
This procedure doesn’t work within qualified accounts such as your 401(k) or traditional IRA because you cannot deduct the losses in a tax-deferred account. This procedure is used with taxable investment accounts.
There are other points to keep in mind. There could be transaction costs (execution fee, commission, etc.) associated with the buying and selling in your account. You need to keep that cost in mind. You also need to keep in mind whether this practice fits with your overall long-term financial plan. Does being in-and-out of the market lead to potential return on investment losses on your long-term investment plans? Or, does tax-loss harvesting end up lowering your cost basis in a particular holding to the point that you ultimately increase taxation on your future gain? And, keep in mind my prior post, Don’t Let the Tax Tail Wag the Financial Plan Dog. It’s generally not a good approach to sell investments solely for tax reasons. All points to consider, so be sure to discuss this practice with your CFP® in advance.
As an independent CERTIFIED FINANCIAL PLANNER™, I can help you plan for the future and make progress toward your goals. Contact me and let’s get started. #talktometuesday #education #Hireaplanner #retirement #stressfree #lifeplan #savings #tax #CFPPro #2022 #taxlossharvesting #taxloss