Tax-loss harvesting is a strategy used by investors to minimize their capital gains tax liability. The technique involves selling securities at a loss and using the losses to offset any capital gains realized. While tax-loss harvesting can be a complex topic, it’s important to understand the basics in order to make the most of your investment portfolio. In this blog post, we’ll explain what tax-loss harvesting is, how it works, and when you should consider using it.
Understanding Tax-Loss Harvesting
When it comes to taxes, there are a lot of strategies that investors can use to minimize their liability. One of these strategies is called tax-loss harvesting.
Tax-loss harvesting is the process of selling an investment at a loss in order to offset capital gains elsewhere in your portfolio. This strategy can be used to lower your overall tax bill by offsetting capital gains with losses.
There are some important things to keep in mind when using this strategy:
First, you can only offset gains with losses – you cannot offset income with losses. So, if you have a job and earn a salary, you cannot use losses from investments to offset that income.
Second, you can only use losses from investments held for more than one year to offset long-term capital gains. Gains on investments held for less than one year are considered short-term and losses from those investments can only be used to offset other short-term gains.
And finally, it’s important to remember that you can only deduct up to $3,000 in losses each year. Any losses above that amount can be carried over to future years.
Example of Tax-Loss Harvesting
When it comes to investing, timing is everything. If you can buy low and sell high, you’ll make a profit. But what if you buy high and sell low? This is where tax-loss harvesting comes in handy.
Below are the investor’s portfolio gains and losses and trading activity for the year:
Portfolio:
- Mutual Fund A: $250,000 unrealized gain, held for 450 days
- Mutual Fund B: $130,000 unrealized loss, held for 635 days
- Mutual Fund C: $100,000 unrealized loss, held for 125 days
Trading Activity:
- Mutual Fund E: Sold, realized a gain of $200,000. Fund was held for 380 days
- Mutual Fund F: Sold, realized a gain of $150,000. Fund was held for 150 days
The tax owed from these sales is:
- Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500
If the investor harvested losses by selling mutual funds B and C, the sales would help to offset the gains and the tax owed would be:
- Tax with harvesting = (($200,000 – $130,000) x 20%) + (($150,000 – $100,000) x 37%) = $14,000 + $18,500 = $32,500
How does Tax-Loss Harvesting work?
Tax-loss harvesting is an investment strategy that involves selling securities at a loss in order to offset capital gains and minimize taxes. The technique can be used in both taxable and tax-deferred accounts, such as IRAs.
One way to avoid the wash sale rule is to buy a similar security that is not substantially identical. For example, if you sell a stock for a loss, you could buy a different stock in the same industry. This way, you can still capture some of the upside potential while offsetting your losses.
Another thing to keep in mind with tax-loss harvesting is that you should have a plan in place for how you will reinvest the proceeds. This is important because if you just let the cash sit in your account, you will be missing out on potential growth.
Finally, remember that tax-loss harvesting is just one tool in your arsenal to reduce taxes. There are other strategies, such as using index funds or exchange-traded funds (ETFs) with low turnover, that can also help minimize your tax bill.
What is a substantially identical security and how does it affect?
A substantially identical security is a security that is similar enough to another security that it can be considered equivalent for the purposes of tax-loss harvesting. This includes securities that are of the same class (e.g. stocks, bonds, etc.) and have the same or similar characteristics (e.g. company size, sector, etc.).
The impact of substantially identical securities on tax-loss harvesting depends on the specific situation. If the securities are truly equivalent, then they can be swapped out without affecting the overall strategy. However, if there are slight differences between the securities, it may be necessary to make some adjustments to the tax-loss harvesting plan in order to account for these differences.
How much Tax-Loss Harvesting can I use in a year?
The IRS imposes limits on the amount of money that can be deducted for various tax-loss harvesting strategies. For example, the maximum deduction for capital losses is $3,000 per year, and the maximum deduction for business expenses is $5,000 per year.
Conclusion
Tax-loss harvesting is a powerful tool that can help investors minimize their tax liability. By selling investments at a loss and using the proceeds to offset gains from other investments, investors can reduce their overall tax bill. While there are some limitations to how tax-loss harvesting can be used, it can be an effective way to reduce your taxes if used correctly.
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Disclaimer: The information provided by LearnToInvest serves as an educational piece and is not intended to be personalised investment advice. ​Readers should always do their own due diligence and consider their financial goals before investing in any stock.