What is Tax Loss Harvesting (and Why It's Better For Your Money Than You Realize)

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With April 15 looming, it's essential to do what you can to prepare for your upcoming tax bill- and beyond. If you had a rough quarter, we know a strategy that might be your portfolio's silver lining; tax loss harvesting. We’ll explain tax loss harvesting and when it might be the right move for your financial portfolio.

What Is Tax Loss Harvesting?

It's no fun to lose, especially within your investments. With the unexpected nature of the market (especially in the current climate), you may inevitably suffer some losses to your financial portfolio. 

These losses can seem particularly troublesome to retirees who rely on their returns to support their living. It’s easy to feel helpless in situations like these and get caught up in the emotions of the loss. After all, your investments have likely been a years-long endeavor- there’s a lot at stake!

But sometimes, losses aren't all that bad. It might sound crazy, but they can offer you a tax lifeline if you're looking for it. That’s where tax loss harvesting comes in. 

Tax loss harvesting is a strategy that enables you to offset your capital losses from capital gains. The strategy involves selling an asset or security at a net loss. You’re strategically using what you already have in investments so that your losses don't hit quite as hard.

Breaking Down the Strategy

Let’s say you have a highly appreciated asset you decide to sell. You know you’ll need to pay capital gains tax on that investment. But if you also have a loss and sell them, you can offset the two, lowering your tax liability.

Here's a basic example. If one stock appreciated and is now worth $1,000, and another stock depreciated and is now worth $500, you could offset the two and only be responsible for $500 in capital gains.

Doing so will not only soften the blow of financial losses but could start new positive momentum should you decide to use the proceeds from the sale to fund more investments. This way, you can see what we meant when we said a loss is not always bad news! 

There are two schools of thought regarding when to apply this strategy. Most often, it is done at the end of the year. Tax loss harvesting at the end of the year can simplify your life by doing everything at once rather than buying and selling at various points during the year.

An investing rule of thumb states that stock prices rise more in January than in any other month. This is another argument for end-of-year harvesting; a likelier chance to gain more from the first month of the following year.

If you feel more confident in your investing and the timing of the market, you may instead choose year-round tax loss harvesting. This way, you won’t miss out on chances throughout the year to gain more. Not to mention, the last few weeks of the year experience lower trading volume. So, while the January rule may increase gains, you risk end-of-year high liquidity costs that might not make the harvesting quite as beneficial. 

The Tax Loss Harvesting Fine Print

Naturally, there are some rules to consider using this strategy. 

First, you can offset a maximum of $3k in ordinary income in a given tax year. If your losses exceed that amount, you may roll it over into the following tax year.

For example, if you have a capital gain of $15k and a capital loss of $18k, you would cancel out the capital gain, then deduct the remaining $3k from your

taxable income. If your loss was higher than $18k, this is where you’d roll into the following year. 

Why is that helpful? If you realized the full $18k, you'd pay more taxes. Whereas if you sell investments that are underperforming and not serving you,

drastically reducing or eliminating your tax liability is possible.

Another rule of tax loss harvesting is that long-term losses must offset long-term gains (assets you have owned for at least one year). The same idea applies to short-term losses and gains (assets you’ve owned for less than one year). The IRS will tax these at different rates

Last but certainly not least is the wash-sale rule. This rule states that if you sell an asset at a loss, then buy a similar or identical asset within 30 days, you can't realize the loss for tax purposes. Investopedia points out that this rule can end up being up to 61 days by the time you’ve waited 30 days, purchased, waited, then repurchased the assets. Also, you can’t try to get around this rule by buying back the sold asset in another account you hold.

When This Strategy Isn't As Useful

Tax loss harvesting can undoubtedly be a sound strategy for efficient investments, but it's only sometimes the best solution.

Remember that it doesn't have the same impact within a tax-sheltered account, like a 401k or IRA, since you don't pay taxes until distribution. There are some exceptions, for example, those with newer or smaller accounts of this nature. In general, though, it won’t make sense since you don’t regularly owe taxes on them. 

You also won’t want to use tax loss harvesting as a strategy if you’re in the 0% capital gains tax bracket. With gains taxed at 0%, this won’t do anything for you. 

You also should reconsider tax loss harvesting if the investment is sold within one year, if losses will increase future tax rates, and when tax savings aren’t reinvested. All three of these scenarios would cancel out the benefits of harvesting. Remember, the goal is to offset losses, so in some instances, you’ll need to have an eye on the future and plan well to do just that. 

Put Your Losses To Work

It’s essential to be intentional when considering rebalancing your portfolio. Stay true to your financial goals, and only consider tax loss harvesting if it fits in with what you want to achieve in the long term and if you can adhere to the stipulations we’ve mentioned.

That being said, you never know when a loss could turn into an opportunity. You should offset your losses to rebalance your portfolio and make your finances more stable and secure. 

Proactive tax planning is critical for retirees, so it's one of our specialties. We can help you build a tax plan that helps you take advantage of your gains and losses. Our Certified Financial Planners® can help determine if tax loss harvesting is a valuable strategy for your financial portfolio. Tax season is approaching, so schedule an introductory phone call with one today!