Tax-loss harvesting offsets capital gains that result from selling securities at a profit, and it is applicable to taxable investment accounts. If you have, say, $5,000 in capital gains and want to minimize the tax liability from those gains, you could sell another security that has gone down $1,000 in value, partially offsetting those gains.
Know the Rules
You may have a great idea to buy back the securities sold at a loss, but there’s a limitation to this practice, called the wash-sale rule, which the IRS uses to prevent taxpayers from creating tax losses using investments.
The rule requires that a loss on a sale won’t be permitted if the same or substantially identical security is purchased within 30 days of the transaction that resulted in the loss. One way to get around the rule is to make sure that you wait at least 31 days to buy it back. Another is to purchase a similar but not identical investment — say you sell energy securities and then buy shares in an energy fund immediately afterward.
Avoid asking your spouse to buy the investment at the same time you sell it for a loss — this doesn’t work. You may think that buying the same investment for your IRA won’t trigger a wash sale, but that doesn’t work either — an IRS decision on such a move nixed it.
Learn the Process
There’s a sequence to tax-loss harvesting: long-term losses are first applied against long-term gains and then against short-term gains. Short-term losses are applied to short-term gains. Why? Long-term capital gains are taxed at a lower rate than short-term capital gains are.
The primary purpose of loss harvesting is to defer income taxes, allowing your portfolio to grow and compound at a faster rate than it would if the money to pay taxes were withdrawn every year gains occur. The benefit will be maximized if you can defer the liability until after you stop working when presumably you’ll be in a lower tax bracket.
Some say tax-loss harvesting may be more of a gimmick than a true advantage. An investor who harvests a loss today might have higher taxes in the future because loss harvesting defers taxes, but it doesn’t eliminate them.
Others see it as creating a kind of tax deferral that works something like a tax-sheltered retirement account, even though your money is in a taxable account. A useful idea is to check your taxable accounts for opportunities to harvest tax losses during market declines. You also can find it advantageous to check several times throughout the year for tax-loss harvesting opportunities, because investments can be volatile.
You can look at the strategy as getting an interest-free loan from the federal government. The benefit is the value of growth generated by the temporary loan. You should try to avoid accidentally turning low-tax, long-term gains into higher-tax, short-term gains.
The maximum write-off for any one year is $3,000. Tax-loss harvesting can provide benefits; the higher your tax rate, the better the benefit, so investors in high-tax states like California and New York can be big beneficiaries.
Another strategy is to take a tax break today and never sell the investment — donate it to charity or pass it down to your heirs on your death.
What’s the best in your situation? Speak with us to discuss the strategies that work for you.