Successful investors understand that building an investment portfolio goes beyond just picking a profitable investment. It’s also about paying attention to the impact of losses and gains on your bottom line and tax burden. Understanding the tips and tricks of tax loss harvesting is the key to a wealth-generating portfolio.
Not every investment is a win. You probably didn’t set out to lose money when you started your investment journey, but it’s the risk you have to take to build a well-diversified portfolio. Some stocks perform well, and some don’t. So what do you do when you lose money on an investment- cut your losses and move on? Yes, but more importantly, turn your lemon into lemonade. And tax loss harvesting is just the way to do that.
What Is Tax Loss Harvesting?
Also known as tax loss selling, tax loss harvesting is an investment strategy that helps you reduce taxes by offsetting gains or income. Tax loss harvesting allows you to sell investments at a loss to offset the gains you’ve realized by selling other stocks at a profit. In turn, you’ll only pay taxes on your net profit. Deducting those losses can offset all the capital gains tax you might owe on the investments you’ve sold for profit.
With this, you’ll only be paying taxes on your net profit, which is the amount you’ve gained minus the amount you lost. As an investor, you can use the proceeds from selling your stumbling assets to buy similar investments that have better potential to grow over time and help you regain your losses.
If you want to make the most of your tax loss harvesting and enjoy its benefit, you must complete your sales transaction before the end of the tax year.
The Basics- How To Tax Loss Harvesting
To understand how tax loss harvesting works, you need to know how capital gains taxes work. When you sell an investment held in a taxable account for more than what you bought it with, you’ve realized a capital tax gain.
When you’re selling an investment asset for a profit, you’ll be owing capital tax gain on the profit- usually based on how long you’ve held the asset before selling it. If you held an asset for less than a year, you’d be paying your ordinary income tax rate on any gains, but if you’ve held it for longer than a year, you’ll pay the preferential long-term capital gain tax rate fixed between 0% and 23.8% depending on your income
That’s where tax loss harvesting comes in handy.
Tax loss harvesting can significantly reduce your income tax burden. When you sell some of your securities and realize the loss on your investments, you can deduct the losses from your capital gains. If there are any leftover losses, you can also offset your taxes on wages and other income with them.
For example, let’s say you discovered that your tech holdings had risen significantly while your industrial stock had dropped drastically. Now that almost all of your investment has been allocated to the tech, if you want to realign your investment with your preferred allocation, you can sell some of your tech stocks and use the funds to rebalance.
How much tax loss harvesting Can I Use in a Year?
Look on the brighter side. While you’ve lost some investment, you’ll end up recognizing a lot of taxable gains. Not only that, if your losses are more than your gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income (of 1,500 each if you’re filing separately as a married couple). Any amount you have left can be carried forward to future tax years to offset the income down the line.
Tax Loss Harvesting Example
Let’s say Amanda invested $50,000 in a tech stock in 2021, but the value dropped to $45,000. She could sell the holding and take a $5,000 loss. Then she could use the proceeds from the sale to buy another stock with similar holdings.
Amanda could then use a $5,000 capital loss from her tech stock to reduce her taxable income for the current year. If she was going to pay a marginal tax rate of 30%, she could reduce her taxes up to $1500 ($5000 x 30%). This way, Amanda could invest her tax savings back into the market.
What To Consider When Using Tax Loss Harvesting
Tax loss harvesting may be a great way to reduce your tax burden and cut your losses, but it also has rules and limitations. For one, tax loss harvesting isn’t useful for retirement accounts such as your IRA or 401K because it’s impossible to deduct generated losses in a tax-deferred account.
In addition, there are limits on using certain types of losses to offset certain gains. For example, a long-term loss can be applied first to a long-term gain, and a short-term loss would first be applied to a short-term gain. If you have any losses in either category, then you can apply them to gains of either type. Lastly, when conducting transactions, you should also consider the wash-sale rule.
What’s The Wash Sale Rule?
The wash-sale rule mandates that if you sell a security at a loss and buy the same or similar security within 30 days before or after the sale, the loss typically doesn’t count for your current tax purposes.
The wash sale rule prevents you from deducting losses when you sell your investment and buy similar securities within 30 days before and after the sale. The best way to avoid the rule is to invest in exchange-traded funds (ETFs), and if you are not switching from one ETA to another, the wash rule will only apply if it tracks an identical index.
Is Tax Loss Harvesting Worth The Effort?
For investors holding securities in taxable accounts-except retirement accounts- tax loss harvesting can be very beneficial and effective. Investors enjoy the opportunity to realize losses and use the sale proceedings to buy other securities, offset their loans against gains, and venture into new investments to enhance their portfolio performance. Without a doubt, tax loss harvesting is usually worth the effort when done correctly.
Take Home
As beneficial and exciting as it seems, without having adequate knowledge, pulling off a seamless tax loss harvesting can add an additional tax burden when not done right. The best way to harness the bounties of tax loss harvesting is to work with best tax strategist like Tax Goddess. Don’t hesitate to reach out to the Tax Goddess team to reap the highest benefits from tax loss harvesting and reduce your overall tax burden.