Viewing your investments like a farmer views their crops is a great way to ensure you’re cultivating growth, managing risks, and harvesting the highest yields.
In today’s post, I’ll explain how you can use the tax-loss harvesting strategy to minimize your tax liability and maximize the success of your financial portfolio.
What is tax-loss harvesting?
In simple terms, tax-loss harvesting involves selling certain investments at a loss to offset gains from other investments or to reduce taxable income. The main goal is to lower the overall tax burden and increase the after-tax returns of your investment portfolio.
However, tax-loss harvesting can only be used with taxable investments, so many retirement accounts, IRAs, and 401(k)s won’t qualify since those are tax-deferred accounts.
What do I need to know about tax-loss harvesting?
To understand tax-loss harvesting, it’s important to understand some key concepts:
Capital Gains and Losses
When you invest in assets like stocks, bonds, or mutual funds, their value obviously increases or decreases over time. If you sell an investment for more than you originally paid for it, the profit you make is called a capital gain. On the other hand, if you sell an investment for less than you paid for it, that is called a capital loss.
Tax on Capital Gains
When you have a capital gain, that gain is taxed. How much a capital gain is taxed depends on how long you held the investment. If you held the investment for more than one year, it’s considered a long-term capital gain and is typically taxed at a lower rate than short-term capital gains, which come from investments you’ve held for one year or less.
Offsetting Gains with Losses
Tax rules provide the opportunity to use capital losses to offset some of your capital gains. You can do this by selling investments that have decreased in value in order to create losses that offset gains from other investments. In this way you can reduce your overall taxable income, which means you’ll have a smaller tax liability.
Wash Sale Rule
The Wash Sale Rule is an important regulation you need to understand when considering tax-loss harvesting. This rule, established by the IRS, prohibits you from claiming a loss on an investment if you buy “substantially identical stock or securities” within 30 days before or after selling the loss-making investment. In other words, you can’t sell an investment at a loss and then turn around and buy that same investment again. If you break this rule, the loss will be disallowed, and you’ll have to adjust your cost basis for the new purchase.
Qualified Dividends
Qualified dividends are dividends that you have held for more than 60 days before, after, or around the dividend date. Your qualified dividends are taxed at a much lower rate than nonqualified dividends, so it’s important to make sure that in the process of tax-loss harvesting you don’t negate those tax benefits by selling investments at the wrong time and creating nonqualified dividends. There are also some other requirements that need to be met for dividends to be treated like qualified dividends. If you’re not sure if your dividends meet the requirements, be sure to check with a tax professional or financial advisor.
Reinvesting Proceeds
After selling an investment to harvest a tax loss, you’ll want to reinvest that money in a similar–but not “substantially identical” investment–in order to maintain your investment in the market and benefit from potential future gains. So you might harvest losses from one investment fund and place that money in a similar investment fund. As long as the stocks held in each of those funds aren’t identical (or close to identical), then you avoid violating the Wash Sale Rule and you still haven’t technically “sold low” or lost out on your investment.
Carryover Losses
If your total capital losses exceed your capital gains during the course of the tax year, you can use your excess losses to offset other taxable income, such as salary or interest income up to a total of $3,000 (up to $1,500 if married filing separately). And if you still have losses remaining after offsetting your capital gains and other income, you can carry those losses forward to future years and use them to offset gains and income in those years. You’ll report capital gains and losses on your Form 1040 Schedule D.
Impact on Long-Term Growth
While tax-loss harvesting can provide immediate tax benefits, it’s important to consider the long-term impact on your investment portfolio. Tax-loss harvesting can be a tricky endeavor, especially if you realize losses and then miss out on future potential gains when investments recover.
Does tax-loss harvesting really save me money in taxes?
Tax-loss harvesting doesn’t eliminate your tax liability. However, if the strategy is used correctly, it is a good way to postpone your tax obligation until you’re retired and likely in a lower tax bracket, which means you’ll pay less in taxes on that money.
While tax-loss harvesting can be a smart tax strategy, it’s crucial to make sure you’re taking a good look at the “big picture” and long-term goals of your investment portfolio before employing this strategy. If you’re unsure if tax-loss harvesting is right for you or you have questions about how to use this strategy to maximize your tax savings, then consult with a tax professional to discuss your specific circumstances.
Like a farmer who utilizes different practices to sustain a farm for the long-term, you should look at investing and tax-loss harvesting as a long-term endeavor. Your aim should be to build wealth over time by deploying various strategies to optimize your financial position.
