We’re well into the last quarter of the year. Now is the time to start thinking about your portfolio and what makes the most sense with it. What do you need to sell? What should you keep? And how will it help with your tax situation?
Tax loss harvesting is an important part of investing, especially if you buy and sell in a taxable account during the year. Here’s what you should know about tax loss harvesting:
First of all, it’s important to understand that tax loss harvesting is a strategy by which you turn investment losses into a tax benefit. It’s about carefully considering which losing stocks to sell in order to offset some of the gains you might have received earlier in the year. It can also be a way to reduce your taxable income.
The main use of tax loss harvesting is to offset capital gains. Did you sell stocks for a gain earlier in the year? If so, you might owe capital gains taxes.
However, you can offset those gains with your losses. Say you ended up selling investments for gains totaling $20,000 throughout the year. Now, you have a losing stock that doesn’t fit your portfolio very well. You decide to sell and log a loss of $12,000. You can use that money to bring down your gains. Now, instead of claiming the whole amount of your gains as income, you only have to claim $8,000 of it.
Depending on your tax bracket, how close you are to the next marginal bracket, and some other factors, that could save you some money on your taxes, since you won’t have to claim as high an income.
You do need to pay attention to long-term and short-term gains since you will match those first.
What if your losses amount to more than you need to set off in capital gains? The good news is that you can use the money to reduce your taxable income.
Let’s say your gains amount to $15,000 throughout the year. You decide to sell some stock and end up losing $19,000. First of all, you’ll get the offset on your capital gains. That leaves you with $4,000 left over.
You are allowed to apply up to $3,000 of your losses to reduce your income. So, in this case, you can lower your taxable income by $3,000. It’s not as good as a credit, but it can still reduce your tax liability.
Plus, you can carry forward any amount you don’t use. So, in our example, you still have $1,000 left over that you can carry over to use next year on your taxes.
Before you get excited about tax loss harvesting, it’s important you understand what you are getting into with this strategy. The IRS has a rule that keeps you from buying an asset that is identical or “substantially the same” within 30 days.
So, you might see something dropping, and believe that it will rebound. You sell it when it drops in price, planning to claim the tax benefit related to the loss. But then you turn around and buy the same thing (or something very similar) at a low price. You expect to see your shares increase in value in the long run — and you got a tax deduction to boot.
That’s what’s known as a wash sale, and it’s not something you’re supposed to do. The IRS will come after you if you try this.
Of course, the main piece to tax loss harvesting is figuring out what to sell.
You don’t want to just sell anything in your portfolio, just to lock in the loss. Instead, figuring out which shares to use in tax loss harvesting is a big deal that should be taken carefully.
Check to see which investments aren’t working in your portfolio anymore. Maybe the fundamentals have changed and you want to unload before problems arise. Perhaps you have acquired other assets that better serve your portfolio and it’s time to make a shift.
Whatever the reason, make sure you sell in accordance with a plan so that you don’t get caught up. In some cases, tax loss harvesting won’t be the best choice. Look at your options and consult with a knowledgeable attorney before making changes to your financial situation.