When you have investments in the stock market, you may be able to reduce your capital gains taxes by using tax-loss harvesting. This legal method of reducing taxes can help you save money each year.
Tax-Loss Harvesting Benefits Large and Small Accounts
There was a time when the only people who could benefit from tax-loss harvesting (TLH) were those with large accounts. Investopedia says this is no longer true, based on a study from the MIT Laboratory for Financial Engineering.The increased use of computers in financial technology (“fintech”) has reduced the cost of transaction fees. Some companies have almost eliminated them, making TLH profitable for nearly any investor.
Some firms that handle investments have automated the tax-loss harvesting process. It reduces the likelihood of mistakes and almost ensures you will benefit from the process.
How the Tax-Loss Harvesting Strategy Works
When you have capital gains from an investment, you must report it to the Internal Revenue Service for tax purposes. You can offset the gain—or some of it—by selling an investment that has been underperforming. To do this, you must sell stocks for tax loss—less than what you bought it for—the basis price. If you purchased stock for $35,000 and sold it for $30,000, you have a loss of $5,000.The $5,000 loss can be subtracted from your capital gains. When tax harvesting, the IRS only allows capital losses of up to $3,000 annually. You can carry losses more than that to any year you want. You do not lose it.
The Tax Consideration
Tax-loss harvesting must always consider whether you must pay taxes for short-term gains or long-term gains. Short-term gains are investments that you have held for less than one year. They are taxed according to your income level and can go up to 37 percent. Long-term gains—those you have held for longer than one year—are taxed much less, only going up to 20 percent.Schwab says that long-term losses are applied to long-term gains first. Short-term gains will offset the gains on short-term gains. Amounts above those gains are applied to offset the other type.
Tax-loss harvesting cannot offset gains on retirement accounts. IRAs and 401(k)s are tax-deferred.
The Wash-Sale Rule
After selling stock for a loss, one tax-loss harvesting rule is that the IRS does not allow the investor to buy that same stock or one that is substantially identical within 30 days before or after the initial sale. If you do, you cannot use the loss to offset any gains.Four Ways to Use Tax-Loss Harvesting
1) When you sell assets of high value, TLH can enable you to reduce your taxes. In today’s volatile stock market, it is easier to find stock you can sell at a loss.Related Stories
2) By carefully reinvesting the money gained from the sale of stock and buying a better-performing stock, you can grow your portfolio faster. Losing money to underperforming stock is only hurting your growth potential.
3) Although you cannot use tax-loss harvesting to reduce retirement account income, if you hold on to some investments after you retire, you can use this method to reduce your taxes. TurboTax says you can sell underperforming stock each year to reduce your income taxes, and if your income is lower during your retirement years, it will also help reduce your overall tax bill.
4) You may also consider selling investments other than U.S. stocks. Morningstar suggests that you might sell non-US stock funds, long-term bonds, and funds focused on various sectors such as energy, utilities, and healthcare.
When Tax-Loss Harvesting Backfires
There is a potential that TLH can backfire if it is not done right. When this happens, it can significantly increase your taxes. Since several facets of the tax harvesting process are not fully predictable, mistakes can occur that lead to more taxes being due.The Best Time to Use Tax-Loss Harvesting and Sell Stock
Most people who use tax-loss harvesting do so near the end of the year. It enables them to make just a couple of transactions and keeps it simple. Others, who may be more experienced, use these methods throughout the year. It helps them catch more opportunities as they appear. Otherwise, opportunities available at other times of the year may not be available near the end of the year.Consider Automated Investing Services
The use of computers in investing, along with artificial intelligence (AI), enables you to take advantage of automated tax-loss harvesting. Although the systems are not perfect, they have a much better chance of getting the timing right when selling and reinvesting your money in better-performing stock.A Warning About Tax-Loss Harvesting
Investopedia gives a warning about attempting TLH without expert advice. Even then, some investment professionals admit that they also get it wrong—and when they do, it costs taxpayers even more money.A Tip for Investors
The Investor’s Business Daily advises selling a stock when it is down 7–8 percent. Continuing to hold on to a stock that goes lower than this only means it will take longer to regain its position—or it may continue to go lower. Instead of waiting to see what happens, you can use your money more wisely on better investments.Instead of using a trial-and-error method of tax-loss harvesting, you are less likely to make a mistake if you talk to a tax advisor or financial planner before attempting it. Since the purpose of TLH is to reduce taxes, let a professional help you get the most benefit from it.
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