Tax Loss Harvesting: Cut Taxes with Smart Investment Moves

What is Tax Loss Harvesting?

Tax loss harvesting lets you sell losing investments to offset gains, reducing your tax bill and boosting your after-tax returns. This strategy work when investments that have decreased in value are sold at a loss for the purpose of offsetting already realized capital gains. 

Your gains and losses work together. If you have investments that went up in value and you sold them for a profit, you’ll pay capital gains tax on that profit. But if you also sell losing investments, you can subtract those losses from your gains. The result is less taxable gains and a lower tax bill.

It sounds simple, but there are important rules and best practices to follow if you want to do it right and get the maximum benefit.

In what situations can you utilize Tax Loss Harvesting?

In order to benefit from tax loss harvesting this year, you’ll want three things to happen:

1. You have realized capital gains from selling an investment
2. Investments that you’re holding and willing to sell have gone down in value
3. Your capital gains are taxed at a rate higher than 0%

Let’s break down how it actually works in practice with an example:

• You purchase shares: For example, you purchased shares of Apple stock for $10,000 in December 2020.
• You sell a winning investment: In January 2022, you sell shares of an unrelated  mutual fund and realize a $15,000 capital gain.
• You sell a losing investment: Your Apple stock dropped in value to $4,000, realizing a $6,000 capital loss.
• Offset the gain with the loss: Now, instead of paying taxes on a $15,000 gain, you only pay taxes on a $9,000 gain ($15,000 minus $6,000).‍
• Use leftover losses wisely: If your losses are bigger than your gains, you can use up to $3,000 of leftover losses each year to reduce other income, like your salary. Anything beyond that rolls forward to future years.

How Can Tax Loss Harvesting Benefit You?

Tax loss harvesting isn’t about picking bad investments, it’s about making the best of inevitable market ups and downs. No investor wants to lose money, but downturns happen. When they do, you can use those losses to your advantage.

• Pay less at tax time, since you’re reducing capital gains tax
• Losses will reduce your taxable income and lower your ordinary tax rates
  
  • Short term losses will potentially provide the greatest benefit because they will be used to offset short term gains first → short term gains are taxed at higher marginal rates
  • If you have more capital losses than capital gains - you can utilize up to $3,000 each year from your capital loss pool to reduce your taxable income.
• Losses may reduce your net investment income tax (3.8%)
• Potentially reduce your Net Investment Income Tax (NIIT)
• Rebalance your portfolio without extra tax pain
• Keep your money working efficiently

When Should You Use Tax Loss Harvesting?

Timing matters. Many investors harvest losses at the end of the year, but you can do it throughout the year if it makes sense for your situation.

To benefit from tax loss harvesting this year, you generally need three things:

1. You have realized capital gains from selling an investment at a profit.
2. You own other investments that are currently worth less than what you paid and you’re comfortable selling them.
3. Your gains are taxed at a rate higher than 0%, which is common for most people with taxable accounts.

Some people also use tax loss harvesting as part of regular portfolio rebalancing. For example, if you want to reduce your exposure to a specific stock or sector, you can sell underperformers to capture a loss and adjust your overall mix at the same time.

An important consideration to note is that tax-loss harvesting does not apply inside IRAs, Roth IRAs, or 401(k)s because those accounts don’t generate annual capital-gains taxes. If you’re trying to reduce future taxes inside retirement accounts, strategies like Roth conversions may be more effective.

Keep an eye 👀 (or two) out for the following

• Selling your investments may be subject to transaction or advisor fees
• If you purchase the same asset (stock, security, etc) within 30 days before or after selling, wash sale rules will be triggered and your sale won’t create a tax loss this year.
  
  • Don’t forget about any auto-buy or auto-sells you have set up!
• You can only take capital losses to the extent you have capital gains (plus an additional $3,000)
  
  • Losses that can’t be used this year can be carried forward indefinitely and can always be used to offset gains. Capital losses generally can only offset ordinary income up to $3,000/year.

• Not coordinating with your advisor or CPA — you may miss better ways to offset gains or losses

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This information is for educational purposes only and does not constitute financial advice. Consult a qualified professional before making any investment decisions.

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References

Code Section 1221‍

IRS Topic 409 Capital Gains and Losses