If you’re familiar with the investment world, you know that gains and losses are part of the game.
And unless you traveled back in time, you’ll lose money at some point.
What if you could turn these seemingly inevitable losses into tax-saving opportunities.
In this post, you’ll learn about tax-loss harvesting and how it can legally lower your tax bill. Let’s get started!
What is tax-loss harvesting?
Tax-loss harvesting is when you sell securities at a loss to offset the taxable gains from another investment.
You lower the tax bill on investments you sold for profit by also selling the positions where you’ll lose money ― Offsetting your loss.
How does it work?
Your tax liability will depend on whether your losses are short-term or long-term. An investment is long-term when you’ve held it for at least a year.
This is a key factor to consider before using this strategy because if your gains are short-term, they’ll be taxed along with your yearly income.
In practice
Let’s say you fall into the 15% long-term capital gains tax bracket (for those who make between $40,000 to $441,500, according to the IRS).
Your portfolio consists of:
- Investment A: $250,000 unrealized gain, held for 450 days
- Investment B: $150,000 unrealized loss, held for 550 days
If you sold investment A, realizing the $250,000 gain, you’d have to pay $37,500 in capital gains tax without tax-loss harvesting.
If you, instead, also sold your shares in investment B and realized that $150,000 loss, your net gains would be $100,000 — lowering your tax bill to just $15,000.
That’s the power of tax-loss harvesting.
Note that we’re offsetting long-term losses against long-term gains. Otherwise, the IRS won’t allow it.
How does it affect my investments?
Many investors like to sell at a loss and immediately buy a similar position at the current, low price.
Emphasis on “similar.” For example, if you sold your gas stocks to minimize your tax bill, you could replace them by investing in a gas fund.
It’s within the same industry, but not the same, which matters a great deal to the IRS.
Many investors love this strategy since it allows them to avoid waiting for 61 days (more on that below) to get their hands on the same stock. After all, a stock’s value can skyrocket during that period, causing them to miss out on a value buy.
The beauty of this strategy lies in the freedom it gives you to re-invest the cash you got from selling at a loss and get stock at a lower price. Not to mention that you didn’t even have to pay taxes on that cash.
Also, you would now buy at a low price and wait for the stock’s value to increase, which gives you more chances of realizing future gains.
The Wash Sale Rule
Before you try to outsmart the system by selling at a loss, buying at a low price the next day, and holding until it goes up, you must know this is not allowed.
Here’s where the Wash Sale Rule comes in. It dictates you can’t sell a security and buy it back within 30 days (either before or after). Turning it into 61 days.
If you do that, it’ll invalidate your loss and you’ll get smacked with a penalty.
Left you a bit puzzled? No need to spin your head in circles, let’s see how this works in practice.
Example:
Sarah buys 200 shares of a stock at $36 per share.
A few months go by and, the stock’s value plummets to $22 per share.
She sells her shares at a loss and buys another 200 shares at $26 per share 3 days later.
This triggers the Wash sale rule because she didn’t wait 30 days before buying more shares. As a result, it nullifies her $14 loss.
Meaning that the stock she purchased at $26 will now have a base price of $40!
Because she wasn’t aware of the Wash Sale Rule, Sarah’s capital gains (if any) will be smaller and her losses bigger.
Talk about a costly mistake.
Action steps:
- Do your research on the best Robo-advisor or brokerage accounts that take care of tax-harvesting for you
- Open an account
- Transfer shares from your other account
- Enjoy the benefits
Wrapping Up
Tax-loss harvesting minimizes losses and lowers taxes on your capital gains.
Since it’s a complex process, you should let an app or software handle this for you.
You can sell a stock at a loss and purchase it once again. But if you do so within the 61-day window, it’ll count as a “wash sale.” — Which will affect you negatively.
All in all, if done correctly, tax-loss harvesting can save you thousands of dollars on capital gains taxes.
Author Bio: John Sandoval
John Sandoval is a personal finance freelance writer and blogger. Through his writing, he strives to dispel the “finance is boring myth” that he once believed in.
