Losses don’t taste too good, but they can reduce your tax bill. A taxpayer is liable for tax only on the net capital gain – realised gains less losses.
For that matter, by selling thinly traded assets of minimal value before the end of the year, you might be able to reduce your final bill for the year, but such action could compromise your long-term returns.
Offset Long-Term Gains With Short-Term Losses
If you sell an investment for a profit, you owe taxes on that profit. But the IRS lets you use your losses from sales during the year or those carried forward from a previous year to cut your profit down before taxing it. This is called tax loss harvesting. This strategy can pay off more effectively on non-retirement accounts, as opposed to retirement accounts (for example, an IRA or 401(k)). This is because losses from those latter accounts are not deductible. In matching gains against losses, the IRS demands that they be ‘substituted for each other’: short-term losses must be first offset against short-term gains, long-term losses can then offset long-term gains, and, if any are left, they can be used to offset ordinary taxable income, but no more than $3,000 a year. But if you don’t consider your overall investing objectives when harvesting losses, it can create a tax-saving trap.
Offset Short-Term Losses With Long-Term Gains
Tax savings from realising losses could be substantial; however, when you sell a loser, it’s important to make sure your due diligence is complete. Maybe a loser hasn’t got as much upside in the long run, so it might be best to cut your losses and move on. Recall that those investments are held in a taxable account, and your marginal (highest) income tax rate is applied to all the gains in the account; because the loss offsets the income from the year, it also offsets the more punitive tax you pay on capital gains. That makes tax loss harvesting doubly valuable for you, a high-tax-bracket investor. Selling investments also incurs transaction costs, such as sales and exchange commissions, and you must be careful to avoid triggering the IRS wash sale rule, which states that if you sell at a loss and purchase similar or ‘substantially identical’ investment from within 30 days of selling, any tax losses that you incur in this process will be disallowed for tax purposes. Therefore, using a robo-advisor for tax loss harvesting could well be a viable option that does not incur additional costs.
Offset Long-Term Gains With Short-Term Losses
Investors can offset capital gains with losses (there are limitations, such as the wash-sale rule which prohibits you from selling something at a loss and immediately purchasing it back, as well as rules regarding short-term gains versus long-term gains). But investors should be sure they have a clear understanding of these limits before utilising this tax break so they don’t find themselves getting unexpectedly taxed when they liquidate an account with gains. Tax-loss harvesting will not make your gains taxes go away – but it will make your investment gains taxes things you have to pay at a later date, when you liquidate an taxable investment account with gains. Make sure that you sell the securities to harvest the losses and then buy a similar replacement to use for your investment purposes so you stay on track with your asset allocation strategy. If you don’t follow these rules, then you’ll beat yourself up because tax savings will be converted into a financial headache. As always, consult with a financial professional to help you implement your tax-loss harvesting strategy so they can explain all the rules of the game, such as what a wash sale is, why you have to be careful with loss carryovers, and whether your loss is considered short-term or long-term.
Offset Long-Term Gains With Short-Term Losses
Harvesting losses works – but it is not necessarily right for every investor. For example, if your portfolio is held in a retirement account such as a 401(k), a health savings account, a 529 plan or a traditional individual retirement account (or IRA), you could not harvest any losses. To avail themselves of tax loss harvesting with a taxable account without triggering a violation of the wash sale rule, funds must be selling off all their investments before 31 December and buying them back again more than 30 days later. For investors who have large short-term gains to offset, tax-loss harvesting might make very little sense. Sure, they might save a few bucks on taxes, but these benefits might be lost in the fees from the transactions and repurchases of securities – and they should talk it through in depth with a financial professional or tax advisor before adopting this tax-savings endeavor.