Tax planning is an integral part of minimizing your tax bill at the end of the year.
Tax loss harvesting is a commonly overlooked form of planning that can save you thousands each year.
If you’re strictly a W-2 employee, your planning options may be limited, but if you have investment income, you might have the option of “harvesting” some of your losses to offset your investment gains.
Read on to learn more about how tax-loss harvesting can help you optimize the returns on your investments, minimize your tax liability and “earn back” some of your capital losses from Uncle Sam.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy to help you reduce your taxable income by selling securities at a loss.
To capitalize on this tax break, losses must be realized. This means whatever security or other investment you own with unrealized losses must be sold. The realization rule applies to both gains and losses, so you can only offset realized gains with realized losses during that fiscal year.
Once you realize your capital losses, you can offset capital gains from any other realized investments, reducing your overall taxable investment income. In doing so, you increase the net returns of your investment portfolio, allowing that money to be reinvested to generate additional returns.
While you aren’t going to make back all of your capital losses, Tax-loss harvesting can offset capital gains from other investments, thereby reducing the total taxes you owe.
Overview of Tax-Loss Harvesting
Tax-loss harvesting plays an essential role in managing your investment portfolio. Here’s how:
- Reduces Capital Gains Taxes: The most immediate benefit of tax-loss harvesting is to offset capital gains realized in the same year from other investments. If you sell investments that have gained value, you’ll have to pay a capital gains tax, but you can offset those gains with capital losses from selling other underperforming investments.
- Offsetting Ordinary Income: If your losses exceed your gains in a given year, you can also use your capital losses to offset ordinary income. The IRS allows up to $3,000 of income ($1,500 if married filing separately) to be offset from capital losses per year, and the remaining losses can be carried forward into future years.
- Improves Portfolio Performance: Tax-loss harvesting can indirectly enhance portfolio performance by providing an opportunity to rebalance your portfolio. When you sell a losing position, you can replace it with an alternative investment to stay true to your long-term investment strategy or purchase the same asset to avoid locking in actual loss
- Defers Tax Payments: When you offset capital gains with losses, you essentially defer your tax payments into the future. The capital that would have been used to pay taxes can instead remain invested and potentially grow over time.
- Compound Growth Benefits: The tax savings from harvesting losses can be reinvested, which could lead to compound growth over time. This additional investment could grow and earn a return, which might eventually compensate for the original loss.
Identifying Investments with Losses
You can identify investments with losses by regularly reviewing your investment account statements or online investment portals. Your brokerage firms will provide you with the current value of your investments along with their cost basis, which is the average purchase price adjusted for any corporate actions like stock splits or dividends.
If the current market value of any of your investments is less than its cost basis, you have capital losses you can harvest. As mentioned above, this would be considered an “unrealized” loss until the investment is sold. It’s important to understand that just because an investment is at a loss does not necessarily mean it should be sold.
Other factors such as your long-term investment strategy and the potential for the investment(s) to recover should also be considered.
Factors to Keep in Mind Before Selling Investments
- Long-Term Strategy: Tax-loss harvesting should not dictate your overall investment strategy. If an investment is temporarily down but fits your long-term strategy and you believe in its potential for recovery, it may not be the best candidate for tax-loss harvesting.
- Asset Allocation: Selling an investment for tax-loss harvesting can affect your allocation makeup and strategy. When selling an investment for a loss, consider replacing it with a similar but not “substantially identical” one. Per the wash sale rule, investors cannot harvest losses if they turn around and buy an extremely similar and highly correlated asset..
- Costs: Be mindful of transaction costs. If the cost of selling an investment and buying a replacement is higher than the potential tax benefit, tax-loss harvesting may not be worthwhile.
Closely monitoring your investments and understanding how changes in the broader market or economy may impact their value is very important. Regular reviews (such as quarterly or semi-annually) can help identify which investments are consistently underperforming and could be good candidates for tax-loss harvesting.
Monetary Value of Tax-Loss Harvesting
To explain the monetary value of tax-loss harvesting, consider the following example: You’ve gained $20,000 from one investment and lost $15,000 on another. If you sell both investments to realize those respective gains and losses you would only be taxed on $5,000 of net capital gains.
This offset can significantly lower the amount of tax you owe, especially if you have substantial capital losses in a given year. And while it doesn’t increase the market returns of your investments, it can increase your after-tax returns, which is ultimately just as good.
Types of Capital Gains
Capital gains are taxed differently based on whether they are short-term or long-term.
Short-term capital gains are gains from assets held for a year or less and are typically taxed at the same rate as ordinary income. The tax rate can range from 10% to 37%, depending on your income tax bracket.
Long-term capital gains are from assets held for more than one year and are taxed at a lower rate than short-term gains. Depending on your taxable income, long-term capital gains rates are 0%, 15%, or 20%. Additionally, a 3.8% Net Investment Income Tax (NIIT) will apply to some high-income individuals.
When using tax-loss harvesting, you can strategically realize losses to offset both short-term and long-term gains. The IRS requires that long-term losses are applied to long-term gains first, and short-term losses to short-term gains first. After that, any remaining losses can be applied to gains of the other type.
Understanding these rules can help you better plan your investment strategy and maximize your tax savings.
Let’s consider a hypothetical scenario to illustrate how to calculate the value of tax loss harvesting.
Assume you are in the 32% income tax bracket and you have realized both short-term and long-term capital gains during the year. You have $10,000 in short-term capital gains and $10,000 in long-term capital gains. In this situation, your tax liability would be $3,200 (32% of $10,000) for short-term gains and $1,500 (15% of $10,000) for long-term gains, bringing your total tax liability to $4,700.
Now imagine you also have a short-term investment that has declined in value by $10,000 and you decide to sell this investment to realize a capital loss of $10,000. You can now use this loss to offset your gains, reducing your overall tax liability.
First, we’ll apply those losses to the short-term gains of $10,000 (as these are taxed at a higher rate). $10,000 loss offsets the $10,000 short-term gains, resulting in a tax liability of $0 for short-term gains. However, you still have a long-term capital gain of $10,000, which would result in a tax of $1,500 (15% of $10,000).
So, by using tax-loss harvesting, you reduce your total tax liability from $4,700 to $1,500, resulting in a tax savings of $3,200.
As you can see, the tax savings from tax-loss harvesting can be significant, especially for investors in high tax brackets with substantial realized capital gains and losses. These savings can, in turn, boost your overall portfolio returns. Moreover, the $3,200 you saved in the example above could be reinvested and, potentially, earn additional returns.
Also, the impact of tax-loss harvesting is magnified if you consistently practice it year after year, strategically realizing losses to offset gains. This continuous deferring of taxes allows your investments to compound on a larger base, potentially enhancing your portfolio’s growth over time.
Reporting Tax-Loss Harvesting to the IRS
According to the IRS, capital gains and losses must be reported on your federal income tax return. This includes gains and losses from sales of stocks, bonds, and other investments, including property. You will need to know the cost basis of your investments (what you paid for them, including fees and commissions) and the price at which you sold them.
Compliance with IRS regulations is essential. Not properly reporting gains and losses can lead to penalties and interest. This includes reporting sales of investments where you’ve broken even or suffered a loss, not just profitable sales.
Start by completing Form 8949. You’ll need to provide details about each investment sale, including the date you acquired the investment, the date you sold it, the sale’s proceeds, the cost basis, and the gain or loss.
Then, separate your investments into short-term and long-term. Each category has its own section on Form 8949, as different tax rates apply to short-term and long-term gains and losses.
After completing Form 8949, you’ll summarize the information on Schedule D of your tax return. Here, you’ll calculate your net capital gain or loss.
Make sure you correctly classify your investments as short-term or long-term. Also, remember that you can’t use losses to offset gains in a tax-free retirement account like an IRA or 401(k).
Tax Reporting Pitfalls to Avoid
Inaccurate reporting can lead to penalties and interest from the IRS. Be sure to keep accurate records and report all investment transactions, not just those that were profitable.
Keeping good records is crucial for accurate tax reporting. You should keep records of the purchase price, sale price, and any investment-related expenses for each of your investments.
Tax-Loss Harvesting Considerations and Limitations
There are several subtleties that should be kept in mind when considering tax-loss harvesting. We discuss them in detail below.
As alluded to earlier, the wash-sale rule is an IRS regulation that prohibits a taxpayer from claiming a loss on the sale of an investment if the same or a substantially identical investment is purchased within 30 days before or after the sale. This rule is intended to prevent investors from selling securities at a loss simply to claim a tax benefit, while still maintaining a position in the investment.
The wash-sale rule can complicate your tax-loss harvesting strategy. If you sell a security to harvest losses, you need to be careful not to violate the wash-sale rule by repurchasing the same or substantially identical security within the 30-day window. If you do, the loss will be disallowed for tax purposes. Instead, you might consider investing in a different security that offers similar exposure but isn’t considered “substantially identical.”
While the IRS does not provide an exact definition, securities issued by the same company or those that track the same index are generally considered substantially similar.
Netting Rules and Carry-Forward Losses
Netting rules are the IRS regulations for how capital gains and losses must be matched against each other. We mentioned this earlier, but it’s worth reiterating. Short-term losses are first used to offset short-term gains, and long-term losses are first used to offset long-term gains. If there are remaining losses, they can be used to offset gains of the other type.
If your total capital losses exceed your total capital gains for the year, you can use the leftover loss to offset up to $3,000 of other income. Any remaining losses can be carried forward into future years to offset future capital gains or income. This ability to carry forward losses can provide a tax benefit in future years, so it’s an important rule to keep in mind.
Alternative Minimum Tax (AMT) Implications
The Alternative Minimum Tax (AMT) is a separate tax system that was designed to ensure that high-income individuals can’t use certain deductions and credits to avoid paying taxes. The AMT has its own set of rates and rules for deductions, which are different from the regular tax system.
Capital losses can still be used to offset capital gains under the AMT, and excess losses can be carried forward, just like under the regular tax system. Because the AMT may disallow certain deductions and adjust certain types of income, it’s possible that your AMT liability could be higher than your regular tax liability, reducing the value of your tax-loss harvesting strategy.
High-income individuals often face a higher tax rate on capital gains, especially short-term gains, which are taxed as ordinary income. They may also be subject to the 3.8% net investment income tax. As a result, tax-loss harvesting can be a particularly valuable strategy for these individuals to offset high capital gains taxes.
In addition to tax-loss harvesting, high-income individuals may consider other strategies like gifting or donating appreciated securities, investing in tax-efficient funds, or using tax-advantaged accounts like IRAs or 401(k)s to reduce their overall tax liability.
Remember that while these strategies can help reduce taxes, they should be used as part of a broader financial plan. Always consult with a tax professional or financial advisor to understand the potential benefits and implications for your individual situation.
Final Thoughts on Tax-Loss Harvesting
Ultimately, tax-loss harvesting is a simple way to offset capital gains and reduce your tax liability. This strategy can potentially save significant amounts of money, especially for high-income individuals who face higher capital gains tax rates.
Harvesting losses may seem easy on its face, but understanding and accurately reporting your capital gains and losses is essential for both compliance with IRS regulations and effective tax planning. Tax laws can be complex and vary greatly based on your financial situation, so consulting a tax professional that can provide personalized advice and strategies tailored to your needs and objectives is highly recommended.
While tax-loss harvesting can be a valuable strategy for managing your investment portfolio and reducing your tax liability, it’s important to remember that it’s just one piece of the puzzle. A holistic approach to financial planning that considers all aspects of your financial life and long-term goals will serve you best. If you think you’re someone who could benefit from tax-loss harvesting, don’t hesitate to consult a tax professional for personalized advice and a detailed course of action to start saving this and every other year.