If you’re looking for ways to reduce your tax bill, you don’t necessarily have to have a long list of write-offs like business expenses, medical costs, or childcare credits. Today, many investors are using strategies like tax-loss harvesting to reduce the amount they owe to Uncle Sam and keep more money in their pockets.
Winning with Investment Losses
If you have investments that have lost value, you might want to consider selling some (or all) of them and utilizing tax-loss harvesting to essentially “balance out” other investments that have done well.
So, what exactly is tax-loss harvesting, and how could it work for you?
This strategy is defined as the selling of securities at a loss in order to offset capital-gains tax liability. Also often referred to as tax-loss selling, this tax-reduction strategy is typically used for limiting the recognition of short-term capital gains—primarily because short-term gains are usually taxed at a higher rate than long-term capital gains.
Tax-loss harvesting can work with a variety of different investment types, including mutual funds, stocks, exchange-traded funds (ETFs), and other securities. For the 2019 tax year, short-term capital gains rates (for investments that are held for a year or less), correspond with income-tax rates—up to 37%, depending on the amount of income you earn.
But long-term capital gains tax rates (which correspond to assets that are held for over one year), are generally lower, with only three brackets—0%, 15%, or 20%—depending on your annual income and filing status (such as single individual or married filing jointly).
This means that the tax rates on long-term gains can be significantly lower than those of short-term gains—in the neighborhood of 20%. With that in mind, the way you opt to take your gains and losses can make a difference in what you can keep and what you have to hand over to the tax man on or before April 15.
As an example, if you have a long-term capital gain of $20,000 (in 2019) and you are taxed at 15%, you’ll owe $3,000 in long-term capital-gains tax. But if you also sell an investment that has a $15,000 loss, your net gain drops to just $5,000 (a $20,000 gain minus a $15,000 loss equals a $5,000 taxable gain). When taxed at 15%, you have a long-term capital-gains tax of just $750—a difference of $2,250.
Selling Your “Losing” Investments
Investors who opt to use tax-loss harvesting will oftentimes implement this strategy near the end of a calendar year, although this does not necessarily have to be the case. In doing so, an investment that has an unrealized loss is sold, which then allows for a credit against realized gains that took place in the portfolio. If the investor wishes to maintain the same asset allocation in the portfolio, they can then simply replace the sold asset with one that is similar.
Considerations before Selling
While tax-loss harvesting can provide you with a viable method of reducing your capital-gains tax liability, there are some items to consider before moving forward. For instance, even though you may purchase a similar asset to replace the one you sold at a loss, the IRS requires that investors wait at least 30 days before doing so. Otherwise, the transaction could be deemed a “wash sale” by the IRS.
A wash sale is a transaction where an investor is seeking to maximize tax benefits by selling an underperforming security at the end of the calendar year so that a loss can be claimed on that year’s tax return.
In addition, tax-loss harvesting is a strategy that only applies to taxable investment accounts. Therefore, it is not meant to be used in tax-advantaged investment accounts like an IRA (Individual Retirement Account) or an employer-sponsored 401(k).
Reducing Your Tax Liability
Tax-loss harvesting is a strategy that can be well worth it, particularly if it helps to increase your long-term average annual investment returns while at the same time reducing your tax liability.
While the concept of tax-loss harvesting is relatively simple, it is important that you first discuss your options with a financial advisor and a tax professional. That way, you can determine if this is a strategy that could realistically work for you. If so, you can then work together with the advisors in deciding which investment(s) make the most sense to sell.
This article appears in the December 2019 edition of OutSmart magazine.