7 Things You Need to Know About Tax-Loss HarvestingSubmitted by Reby Advisors | Certified Financial Planners | Danbury, CT on September 26th, 2019
By George Koeltl, CFP®, September 26, 2019
Investing is the best way to build wealth in the long run. However, not every investment will be a winner, and even your best investments will temporarily fluctuate in the wrong direction. Fortunately, these setbacks often come with a silver lining: you can use them to reduce your taxes.
Here are the basics on how to do that with tax-loss harvesting, also called tax-loss selling:
1. How tax-loss harvesting helps you turn losses into tax breaks:
Tax-loss harvesting is the process of capturing opportunities to minimize your taxes by selling investments at a loss, then using that loss to reduce your overall capital gains and, accordingly, the taxes owed on them. Investment losses get repurposed into tax breaks. It works for both short-term and long-term capital gains.
Many different investors can benefit from his strategy—it isn’t just for the wealthy, though it does work best for those in higher tax brackets. You can use the losses to offset your capital gains taxes or, if you don’t have a lot of those, your regular income tax.
2. You’ll need to know a few tax-loss harvesting rules
When you decide to use tax-loss harvesting as a strategy, keep the following in mind:
- The deadline for harvesting is the end of the calendar year (December 31st). You can’t wait until tax season to get started.
- You may not invest in the same stock or fund within 30 days of the one you sold and claimed as a loss. This also applies if the stock or fund is very similar, or if your spouse invests in the same stock or fund that you sold and claimed as a loss. If you do this, your loss will be disallowed.
- And, if you want to report a loss to the IRS, you will need thorough records of each purchase. This allows you to come up with the correct cost basis.
These aren’t the only rules you’ll need to know for tax-loss harvesting, but it’s a good start.
3. Tax-loss harvesting is only applicable to investments held in taxable accounts
Tax-loss harvesting is designed to offset taxable gains, so it can’t be done on investments in tax-sheltered accounts. This automatically disqualifies your IRA, 529 plan, 401(k) and any other account that is not taxable.
4. Pay close attention to the difference between long-term and short-term capital gain tax rates
If you’ve held an investment for more than a year, you’ll be taxed at the long-term capital gains rate, a certain percentage based on your tax bracket. If you’ve only held the investment for less than one year, it’ll be taxed as ordinary income. For most people, the tax rate paid on capital gains will be less than the rate paid on ordinary income.
If you harvest a long-term loss, it must be applied first to offset a long-term gain. And if you have a short-term loss, it must be applied first to offset a short-term gain. Anything that is “left over” can be applied to the other type, but only after first applying it to its own type. So, don’t get your long-term and short-term capital gains mixed up when reporting your capital gains and losses.
5. You’re allowed to offset a maximum of $3,000 per year, but you can carry it forward
You can’t just claim as many losses as you want each year. You can claim a maximum of $3,000 to offset taxable income (or, if you are single or married and filing separately, each individual may claim $1,500). You might have more investment losses than the limit allows you to claim, but you need to abide by the yearly limit. You can, however, apply the “extra” amount to next year’s capital gains. Carry forward the tax loss to the following year, and if you still have overage, continue applying it each year until the entire amount is used up.
6. You shouldn’t sell losing investments solely for the tax break
This should go without saying: don’t sell losing investments just for the tax break! Investments are, in general, more beneficial when you keep them around for the long haul. Short-term volatility is normal and does not mean that something isn’t a good investment.
Don’t be too quick to sell stocks or funds that aren’t performing well right now. Within a well-designed portfolio, you should hold onto investments and allow them to achieve long-term growth. Over the long-run markets have always gained value.
7. For best results, immediately re-invest money from your losses
When you harvest your tax losses, you’ll lower your tax bill for the year, which is great! But it’s even better if you put that money to use for long-term growth. Invest the money into something that will rebalance your portfolio and continue to build your wealth.
Here’s a Tax Loss Harvesting Example
Let’s say you own one “lot”—or 100 shares—of an International Equities Fund that has declined in value by $3,000; you purchased this lot for $13,000 two years ago, and it’s now valued at $10,000. You also own one lot of a U.S. Equities Fund that has increased in value by $3,000, from $7,000 at the time of purchase three years ago to $10,000 today.
If you need $20,000 of income from your portfolio, you can sell both of these lots for $10,000 each and owe nothing in capital gains. The $3,000 loss from the sale of the International Equities Fund offsets the $3,000 gain from the U.S. equities fund.
Early in the 4th Quarter Is a Great Time to Harvest Losses
The deadline to sell investments for the purpose of tax loss harvesting for the 2019 tax year is December 31, 2019. Now is a good time to start looking for opportunities because you’ll have time on your side. As the deadline nears, you can always harvest additional losses if it’s wise to do so, but you can never turn back the clock if a loss you could have used turns out to be a gain.
If you would like additional advice on how to minimize your taxes in the long run, please do not hesitate to contact Reby Advisors.