How to Lower Your Income Taxes with Tax-Loss Harvesting
Wouldn’t it be nice if every investment was a winner? While not every investment will make you money, there are strategies to help you make the most of a loss. On this episode, I’m going to show you the dos and don’ts of tax-loss harvesting so you can lower your income taxes and soften potential losses in the market.
Key Takeaways:
· What is tax-loss harvesting?
· Examples of tax-loss harvesting
· Four things to be aware of when developing a tax-loss harvesting strategy
· Do your tax-loss harvesting homework
What is Tax-Loss Harvesting?
Unfortunately, not all our investments can make money. There are bound to be a few that do not perform well and result in a loss. While this is not ideal, there are strategies that you can employ to turn that poor investment into a benefit. One way you can do this is through tax-loss harvesting which you should always consider when investing.
Tax- loss harvesting begins with a loss. For example, if you purchased a stock for $100 and it’s now worth $92, then you have a loss of $8 per share. If you had purchased 100 shares, then you would be at a loss of $800 ($8 per share x 100 shares). Which means that your initial $10,000 investment is now worth $9,200. At this point, you have a few decisions to make. You could either continue to hold the stock or sell it.
You cannot harvest tax-losses until you sell the position and lock in the loss. Positions sold within one year are considered short-term capital gains/loss while those held for longer than a year are long-term capital gains/losses. If you were to sell the position above, then you could either offset the taxable gains from your other positions or reduce your ordinary income for that year by up to $3,000. To put simply, the losses that you take can be used to reduce the taxes on your gains in that year.
If you have losses in a stock that you still want to hold then consider this. You can always reinvest that money into a similar investment, so you do not miss the potential recovery. However, you cannot repurchase the original or identical security within the next 30 days because that is known as a wash sale. Otherwise, you won’t be able to use the losses for deductions. Therefore, if you took a loss on AAPL, but wanted similar exposure then you would need to find a distinctly different security. In this case, I would suggest choosing a technology index such as QQQ to get the technology exposure.
Examples of Tax-Loss Harvesting
Let’s go through an example to better understand tax-loss harvesting. Imagine that you sold a few investments earlier in the year and incurred $20,000 of short-term capital gains. If you were subject to 30% of State and Federal tax, then $6,000 of that $20,000 would be collected in taxes when you filed your taxes. If you had $25,000 worth of losses in another investment account, then you could sell the position(s) and offset the gain of $25,000.
This would leave you with $5,000 worth of losses on the year, but we aren’t done yet. Of that $5,000, you can take $3000 of it and deduct that against your ordinary income (if any). The remaining $2,000 of losses can be rolled over and be used to offset future gains. So, in the next year if you have $10,000 worth of gains, then you can begin by offsetting it by the $2,000 that we rolled over today.
For another example, imagine you were down $15,000 on a position that you have held for over one year and want to lock in the long-term capital loss. So, you would sell that investment this year. If you have no other capital gain for the year, then you’d be able to deduct $3,000 of that $15,000 loss from any ordinary income that you have. Then the remaining $12,000 of losses would be carried forward for use in the following year if you had any other gains. If not, you could deduct another $3,000 of ordinary income each year until the rolled-over losses balance runs out.
Four Things to be Aware of When Developing a Tax-Loss Harvesting Strategy
If you are interested in tax-loss harvesting, then there are a few factors that you need to know. First, you cannot use this strategy in a retirement account. This includes any Individual Retirement Account (IRA), 401(k), 403(b), 457, Roth IRAs, etc. The investments within these accounts grow tax-deferred so there are no taxes incurred when a position is sold. For this reason, these accounts cannot take advantage of tax-loss harvesting.
The second factor you need to know is that harvested losses must first be used to offset like-gains. This means that short-term losses first need to be applied to short-term gains and the same goes for long-term gains and losses. Once you have done that, if there are any remaining losses, then you can deduct those on your taxes.
The third factor is the wash sale which I briefly covered before. The reason that it’s brought up again is that I want this point to be understood. You cannot repurchase the original or an identical security within 30 days after selling for tax-harvesting. If you do, then you cannot use them to offset any income. The losses would be locked in; however, you would not receive the benefits of tax-loss harvesting because you repurchased the same or an identical position within the following 30 days.
The fourth factor you need to understand is that tax-loss harvesting applies to all of your taxable accounts as they are viewed as a whole. Let me explain, imagine you had two brokerage accounts, one at Charles Schwab and the other at Fidelity. For the sake of the example, let’s say that you solely had gains in the Charles Schwab account and only losses in the Fidelity account. If you took the losses in the Fidelity account, then you could use them to offset the gains in the Charles Schwab account. This is because the government views your taxable accounts as a whole, it does not matter if they are held are two different custodians.
The same would go for wash sales. You cannot take tax losses in your account with Fidelity Schwab, and then purchase the same or identical position(s) in the account with Charles Schwab. Another conflict could arise if you have automatic contributions and investment into one of your retirement accounts. If any of those positions purchased is the same or identical to the one you sold in your taxable account, then that will still be considered a wash sale. Unfortunately, the same can be said for your spouse’s accounts which was ruled years ago in 2008. Therefore, you must take your time and plan accordingly when preparing to harvest your tax losses.
Do Your Tax-Loss Harvesting Homework
As you can see, you need to do your homework before tax-harvesting. And additional homework going forward is to monitor your taxable investment accounts for opportunities to harvest tax-losses. The current financial markets are volatile as the outlook of bullish and bearish Wall Street Analysts conflict. Therefore, the best thing that we can do is hope for the best, but prepare for the worst. If the market sees a significant decline in the future then it could open many opportunities to harvest tax-losses so you need to be attentive.
Now let’s cover where you can find this information. The first step is to log in to your taxable investment account. From there, you need to locate the Cost Basis tab/report. You can simply call the support team at your custodian for help if you cannot find it. Under the cost basis screen, you should see each position listed with values for the short-term and long-term capital gains/losses. This would be the time when you would evaluate whether you should harvest tax losses, and next which positions you would sell.
If you would like help with this process then I would suggest contacting a Financial Planner or Accountant. Either should be able to help you with this process. I personally offer a Free Consultation where we could determine if my services would be a good fit for you. Therefore, don’t let the lack of resources or confidence prevent you from taking advantage of our topic today, tax-loss harvesting.
