Smart investors are always looking for ways to reduce their tax burden. While no one can avoid taxes entirely, harnessing tax loss harvest opportunities is a smart way to save.
Nobody buys an investment with the expectation that it will lose money. However, harvesting tax losses provides a unique opportunity to capitalize on downturns as they occur.
By harvesting tax losses, you can use the loss on investments to offset your realized capital gains and / or a portion of your normal taxable income. Read on to find out all about how it works!
What is Tax Loss Harvest?
Before we dive into the guides on how to harvest tax losses, it is important to first understand what it is. In essence, tax loss harvesting is a strategy of selling investments that have decreased in order to lower your tax liability.
After this transaction, the investment sold at a loss will offset realized capital gains. And with that, you can reduce your taxable income for the year. Sold investments are then replaced with similar investments in the hopes of generating a profit with future growth.
Tax loss harvesting can be a useful strategy for investors looking to minimize the taxes they owe on their investments. Let’s take a closer look at the pros and cons of harvesting tax losses.
How to reap tax losses
Many robo-advisors offer automatic tax loss harvesting as part of their advisory services. However, if you are interested in doing the tax loss harvest yourself, the good news is that it is a relatively straightforward process.
Step 1: Monitor your investment for depreciation
Take the time to monitor your portfolio for out-of-value investments. If you see a significant loss in the value of your investment, it may be time to consider a tax loss harvesting strategy.
Step 2: Sell Investments at a Loss
If you find an investment that has depreciated, you can sell it. At that point you will experience a capital loss. Without the action of selling the investment, the capital loss will be unrealized and you will miss the chance to reap the tax losses.
For example, let’s say you invest $ 10,000 in a mutual fund. Six months later, the investment has dropped to $ 8,000 in value. If you miss the chance to sell your investment and it recovers to $ 11,000, you cannot use the temporary depreciation to reduce your tax liability.
Step 3: buy back a similar investment
Once you’ve sold your original investment, it’s time to put your money back into your home. When choosing a new investment, you need to make sure that you are buying something similar but not identical.
The IRS does not allow you to continue harvesting tax losses by acquiring identical investments, also known as laundry sales. A similar investment cannot be “substantially identical” to the original investment.
However, it is possible to buy different ETFs that target similar industries. Buying a similar investment will allow you to stick to your overall investment goals while taking advantage of short-term losses to minimize your tax burden.
Step 4: claim the loss
Once you have completed the mechanics of a tax loss harvest transaction, the next step is to claim the loss on your tax return. This last step is a meaningful way of realizing the tax loss.
Depending on your capital income tax bracket, this tax minimization strategy could save you thousands.
Restrictions on harvesting tax losses
While harvesting tax losses can be an exciting way to potentially save thousands, there are a few caveats to keep in mind. These restrictions were set by the IRS to prevent abuse.
Washing sales rules
The laundry sale rule prevents investors from attempting tax losses with identical investments. According to this rule, when you sell a security, you cannot claim a capital loss against a capital gain on the exact same security.
This prevents you from buying and selling identical securities in order to recover a loss of capital for 30 days before or after the sale. If you continue buying and selling identical securities within 30 days, you will not be eligible for a tax write-off under the IRS.
It is important that you can replace investments with similar mutual funds from ETFs. With similar mutual funds, your investment portfolio can be relatively similar without breaking the laundry sale rule.
Taxable services only
The harvest of tax losses is only possible on taxable investment accounts. Other tax deferred investment accounts like an IRA or 401 (k) do not benefit from the harvest of tax losses because they are not subject to capital gains tax.
Limitation of offsetting ordinary income
There is no limit to the amount of investment gains that can be offset by harvesting tax losses. However there are Limitation of the amount of taxes on ordinary income that can be offset.
As a married couple filing together or as a single applicant, you could experience capital losses of up to $ 3,000 to reduce your normal taxable income in any given year. If you are a married couple filing separately, you can only claim capital losses up to $ 1,500 in any given year.
Because of these restrictions, in certain years you may have more capital gains losses than you can claim on your tax return. The good news is that you can carry these losses over to future tax years.
If you want to enter into a tax loss transaction every time one of your investments depreciates, the strategy can become onerous in several ways.
First, there may be transaction costs if you don’t have a commission-free stockbroker. Second, frequent harvests of tax losses can lead to higher tax preparation costs when it comes to filing your tax return.
Before implementing tax loss harvesting in your own portfolio, weigh the cost of completing the transaction and filing your taxes. You don’t want to go to the hassle of reaping a tax loss if the costs outweigh the savings.
If you are considering harvesting tax losses, you shouldn’t prioritize this strategy over the value of a balanced portfolio. While this strategy can save you on your tax burden, it should not take precedence over building a portfolio that meets your investment goals.
When you begin your investment journey, use our free resources to build a portfolio that works for you. And if you are looking for an option to harvest tax losses, you may want to open an account with one of the best robo-advisors who can automatically perform all transactions on your behalf.