If you’ve noticed an underperforming investment in your portfolio, you might have a silver lining available to you: tax-loss harvesting. This strategy allows you to offset taxable capital gains with your capital losses. Through this process, you can reduce your tax bill and improve your overall portfolio going forward. We’ve previously covered the topic when it comes to crypto, but here’s what to know about tax-loss harvesting for the typical investor.
What is tax-loss harvesting?
Tax-loss harvesting is a technique to sell certain investments at a loss in order to lower the amount of taxes paid. By strategically taking this capital loss, you can offset the taxes owed on your capital gains, e.g. your investments that sold at a profit. At the same time, you can replace the underperforming investments with similar ones in order to better position your portfolio.
What is the advantage of tax-loss harvesting?
Whenever you sell an investment for a profit, you’ll owe some capital gains tax accordingly. And when you cash out an investment, that tax can get hefty—up to 37% if you sell within a year. However, the recorded loss that comes with tax-loss harvesting offsets those gains. Remember: The benefit here is tax deferral, not tax cancellation.
In addition to reducing taxes owed, the other idea behind tax-loss harvesting is that you’ll use your freed up cash to buy new assets to replace the investments you sold at a loss. These new assets will likely be similar to the ones you sold, so that your asset allocation and risk profile remain largely the same. Ideally you’ll be able to rebalance your portfolio to generate more positive performance, while not drastically changing your overall investment goals and strategies.
As Fidelity puts it, the goal of tax-loss harvesting is that less of your money goes to taxes and more money stays invested and working for you.
Is tax-loss harvesting right for you?
According to Forbes, even tax payers who do not report capital gains can benefit from this technique, since investment losses can also be used to offset taxes on your ordinary income. However, as with all things taxes, there’s a lot to carefully consider before you dive head-first into tax-loss harvesting on your own.
First off, tax-loss harvesting is relevant only for taxable investment accounts, not tax-deferred retirement accounts like a 401(k) or an IRA. The investments sold can be any tradable security: stocks, bonds, or even cryptocurrencies.
Although you don’t need hefty capital gains to practice tax-loss harvesting, the strategy is mostly relevant for investors in higher tax brackets. The higher your income, the more money is saved by reducing taxable gains; plus, the more money you make, the more likely you are to mess around with your invested assets. On the other end of the spectrum, anyone earning less than $40,000 as single filer or $80,000 as joint filer won’t owe anything on their long-term capital gains; tax-loss harvesting is irrelevant for them.
Here’s information from the IRS for reporting your capital gains and losses. Charles Schwab also provides a helpful explanation for how you can use tax-loss harvesting with an ordinary income.
What else to know before you try tax-loss harvesting
Attempting to harvest losses can do more harm than good. Forbes explains that you should not prioritize tax-loss harvesting over your primary investment strategy or objectives. This technique should also only be used when you can “immediately reinvest in a suitable (but not identical) replacement that preserves the overall strategy.”
There are rules and restrictions to keep in mind while navigating this sort of transaction. Primarily, be aware of the wash-sale rule, which prevents you from selling a stock a loss and then rebuy that same (or a “substantially identical”) stock within 30 days.
At the end of the day, unless you’re a tax expert yourself, you should consider enlisting the help of one. No matter what, you’ll need to keep good records of your transactions, in case you ever face the wrath of the IRS down the line. And if you don’t want to invest in working with a tax professional, you can always consider robo-advisors.
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