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5 Things You Should Know About Tax-Loss Harvesting

5 Things You Should Know About Tax-Loss Harvesting

By Jeremy Raffer

 

Tax-loss harvesting is the process of selling investments at a loss so you can offset gains and reduce the amount of tax you have to pay. If you know what your doing, you can use your losses to help your tax bill in the long run. There are specific rules around this practice though, but if done correctly, it can be a great tool for your investment portfolio, and can really help you financially.

 

Tax-loss harvesting

 

Table of Contents:

1. How Does Tax Loss Harvesting Work?

2. How Can I Use It?

3. Selecting Your Cost Basis

4. What’s The Wash-Sale Rule?

5. What About Taxes?

Summary

 

1. How Does Tax Loss Harvesting Work?

 Realized losses are the losses you’ve taken into your account by buying something at a high price and selling it at a low.When you file your taxes, you’re allowed to offset any ordinary income up to $3,000, as well as an unlimited amount of investment gains using realized losses.

For example, let’s say last week you bought 100 shares of a security at $250 per share--totaling $25,000. Today you look and see that each share is only worth $240 now, which means you’re down $1,000 on your investment. You haven’t sold it yet though, making this loss “unrealized.”  An unrealized loss is simply the potential loss if you were to sell it right now. Tax-loss harvesting is the process of realizing that loss by selling it, and then on your taxes, applying that loss to offset $1000 of income from other investment gains--reducing how much tax you have to pay when the time comes.

 

2. How Can I Use Tax-Loss Harvesting?

This philosophy of tax-loss selling makes a lot of people view the drawdowns in the market differently. When the market pulls back 5%, 10% or 15%, what I like to do is take a look at my accounts and see if there are any positions that have a loss that can be taken advantage of. It doesn’t mean that those losses have to be used in that tax year either.

In fact, losses can stay on the books and be used to offset future years’ income and gains. This strategy can be a good way to build up losses to offset an investment that did unexpectedly well, but has a large tax burden once you sell. 

 

3. Selecting Your Cost Basis

When harvesting your losses you don’t have to sell an entire position or investment. Say you invested once at the beginning of the year and again in the middle. You probably made the purchase at different prices, and one could be at an actual gain or just breaking even, while the other is at a loss. Make sure you select the proper one to sell when you harvest to maximize the loss. If you just blindly wipe your losses, you may not be doing yourself any favors. The different prices you bought an investment at are called tax-lots. Managing the tax-lots intentionally can help you maximize your gains and minimze your losses.

 

4. What’s The Wash-Sale Rule?

As with most investing strategies, there are various factors to be aware of. For tax-loss harvesting, it’s called “the wash-sale rule” and it dictates a few key points. Whatever you sell can’t be repurchased for 30 days for the tax loss to be used. Additionally, you can’t purchase what the IRS considers “substantially similar investments.” The IRS doesn’t actually define what “substantially similar investments” are though, so there are some gray areas you need to be cognizant of. For example, you cannot sell an ETF (exchange-traded fund) from one family of funds, and then buy a substantially similar ETF from another family. You can, however, sell a biotech stock and buy the biotech ETF. Another thing you could do is sell one bond and buy another. This is possible because they have different coupons and maturity dates--ensuring they’re not “substantially similar.” This is a popular strategy because you may want to take a loss but not me out of the market.

 

wash-sale rule


What About Taxes?

Another thing to be aware of is the difference in tax rates between long-term gains and short-term gains. Long-term capital gains are taxed at 15% or 20%--depending on how much income you generate from your job. However, short-term capital gains are taxed based on your income tax rate--which for many is higher than 15% or 20%. When taking advantage of the “wash-sale rule” you'll want to be aware of the tax rate before you switch back into your original investment.

 

long-term gains vs short-term gains

 

Let’s say you own a specific security and take a tax loss on it. You wait the required 30 days so that you can use the loss and you’re prepared to switch it back into that same security. Before switching back, take a look at how much that security has generated in returns over the period you’ve owned it. In most cases there isn’t a huge move in a 30 day period, but sometimes an investment can generate enough growth that the short-term capital gains tax rate becomes a hindrance. In this case you’ll have to consider whether it’s worth switching back to the original strategy or if you want to hold that position for a year--when the gains will be taxed at the long-term rate of 15% or 20%.

 

Summary

People hate taxes and they can be a strong motivator in the wrong direction. Just keep in mind that your investing strategy and asset allocation should take precedence over trying to save on taxes. Don’t let your efforts to minimize taxes affect your asset allocation and investment diversity (or as they say, don’t let the tail wag the dog.) So remember to carefully scrutinize your accounts and realize your losses at the appropriate times. Pay close attention to the price you purchased investments at as well, and make sure you calculate what your tax liability would be when you switch back into your original investment. Have you ever tried tax-loss harvesting? Let us know in the comments below.

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Jeremy Raffer, MBA
Wealth Manager
 
Phone – 201-773-4641
 

 

Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation.  While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.  Any opinions are those of Jeremy Raffer and not necessarily those of Raymond James.

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