A Beginner’s Guide To Tax-Loss Harvesting
As the end of the year approaches, you may be looking at your investment portfolios and are probably beginning to assess how much capital gains tax you’ll have due. Chances are, no matter how much you have invested in equities, some of them increased in value, while others decreased, resulting in a loss.
If, across all your equity investments, you made more than you lost, than you should consider tax-loss harvesting.
What Is Tax-Loss Harvesting?
In its simplest form, tax-loss harvesting is a financial strategy aimed at minimizing capital gains taxes on your investment portfolio. The basic principle is to sell certain investment assets at a loss in order to reduce your tax liability at the end of the year.
You can use tax-loss harvesting to offset capital gains that result from selling securities at a profit. You can also use tax-loss harvesting to offset up to $3,000 in non-investment income. You cannot, however, apply this strategy to tax-deferred retirement accounts like IRAs and 401(k) accounts. Those types of accounts aren’t subject to capital gains taxes.
As an example, if certain stocks you own generated a $10,000 profit this year in a taxable investment account, while others resulted in a $5,000 loss, you can sell those losing stocks at a loss to cut your capital gains (and therefore, capital gains tax) in half. While it may sound like selling assets at a loss defeats the purpose, there is an actual advantage to it.
Benefits Of Tax-Loss Harvesting
Tax-loss harvesting can involve both long-term (more than a year) and short-term (less than a year) capital gains. Because of this, there is a specific sequence for how losses should be applied.
Long-term losses are first applied against long-term gains, and then against short-term gains. Meanwhile, short-term losses are applied first to short-term gains. This sequence takes place because long-term capital gains are taxed at a lower rate than short-term capital gains.
It’s important to understand that the primary purpose of tax-loss harvesting is to defer income taxes. That’s the process of delaying the payment of taxes many years into the future. Deferring taxes allows an investment portfolio to grow and compound at a faster rate than it would if the money to pay taxes were withdrawn from the portfolio every year that gains occurred.
The benefit will be fully maximized if you can defer the liability until after you stop working, when you will presumably be in a lower tax bracket.
Getting Help With Tax-Loss Harvesting
The one drawback to implementing a tax-loss harvesting strategy is that actually doing it can be quite complicated without specific knowledge and software made for the exact purpose.
In certain situations, it may be advantageous to buy back the securities sold at a loss at a later date, or replace them with similar investments. However, a rule created by the IRS, called the Wash-Sale rule, imposes limits on how and when this can be done.
While some brokerage firms will offer tax-loss harvesting as an additional service (at an additional cost, of course) it’s a good idea to first speak with a experienced financial planner who can evaluate your portfolio’s performance and make a recommendation.
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