Thinking About Taking Year End Tax Losses? Don’t Make These Mistakes

Given the stock market’s performance this year, you may be thinking about taking some losses—otherwise known as tax loss harvesting. It’s a good strategy when investments in a taxable account decline, but you want to avoid some traps.

Tax loss harvesting is simply selling investments in taxable accounts that have paper losses so the loss becomes tax deductible.On your tax return, capital losses first offset any capital gains you have for the year. Each dollar of taxable loss you recognize allows you to recognize a dollar of capital gains tax free.

If capital losses for the year exceed capital gains, up to $3,000 of excess losses can be deducted against the other income on your tax return. When capital losses for the year exceed capital gains plus the $3,000 deduction, the excess losses can be carried forward to future years to be used in the same way.

Selling a losing investment can shelter other gains or types of income from income taxes and frees up the capital to be invested in something else.

Of course, you probably purchased the investment because you expected it to appreciate. If you still like the investment’s longer term prospects, you can buy it back after selling it. But you have to avoid the wash sale rule.

The wash sale rule says you have to wait more than 30 days (not 30 days—more than 30 days) to repurchase the investment or a substantially identical one. If you don’t wait long enough, the loss isn’t deductible. It’s added to the basis of the new investment and effectively the deduction is delayed until that investment is sold.

The wash sale rule also applies if you bought the substantially identical investment 30 days or less before you sold the losing investment.

So, the first rule is to avoid buying a substantially identical investment within 30 days of selling the investment.

You can buy an investment that isn’t substantially identical within 30 days of the sale. For example, you can sell one tech stock and purchase a different tech stock, even one in the same sector. Or sell a biotech stock and buy shares in a biotech ETF.

Another action you can’t take is to buy a substantially identical investment in an IRA or 401(k). The IRS ruled some years ago that the wash sale rule is violated when an individual investor sells an investment in a taxable account and within 30 days buys the same investment in an IRA or 401(k). It’s one case when the IRA isn’t treated as a separate taxpayer.

Here’s a related point. When you have a losing investment in an IRA, you won’t be able to deduct the loss on your individual tax return. A loss in an IRA is deductible only in the rare case when you fully distribute all your IRAs of the same type (traditional or Roth), and the proceeds are less than your aggregate cost basis in the IRAs.

Source: Thinking About Taking Year End Tax Losses? Don’t Make These Mistakes

Critics by Hayden Adams

Tax-loss harvesting—offsetting capital gains with capital losses—can lower your tax bill and better position your portfolio going forward. Even in the best of times, not every investment will be a winner. Fortunately, a losing investment does have a silver lining: You may be able to use your loss to lower your tax liability and better position your portfolio going forward. This strategy is called tax-loss harvesting, and it’s one of the many tax-smart strategies that investors should consider.

Tax-loss harvesting generally works like this:

  1. You sell an investment that’s underperforming and losing money.
  2. Then, you use that loss to reduce your taxable capital gains and potentially offset up to $3,000 of your ordinary income.
  3. Finally, you reinvest the money from the sale into a different security that meets your investment needs and asset-allocation strategy.

The general principle behind tax-loss harvesting is fairly straightforward, but it’s best to plan your strategy to avoid some common pitfalls.

The basics of tax-loss harvesting

Imagine you’re reviewing your portfolio, and you see that your tech holdings have risen sharply while some of your industrial stocks have dropped in value. As a result, you now have too much of your portfolio’s value exposed to the tech sector. To realign your investments with your preferred allocation, you sell some tech stocks and use those funds to rebalance. In the process, you end up recognizing a significant taxable gain.

This is where tax-loss harvesting comes in. If you also sell the industrial stocks that have declined in value, you could use those losses to offset the capital gains from selling the tech stocks, thereby reducing your tax liability.

In addition, if your losses are larger than the gains, you can use the remaining losses to offset up to $3,000 of your ordinary taxable income (for married couples filing separately, the limit is $1,500). Any amount over $3,000 can be carried forward to future tax years to offset income down the road.

For example, let’s say you recognize a gain of $20,000 on a stock you bought less than a year ago (Investment A). Because you held the stock for less than a year, the gain is treated as a short-term capital gain and will be taxed at the higher ordinary-income rates rather than the lower long-term capital-gain rates, which apply to investments held for more than a year.

At the same time, you also sell shares of another stock for a short-term capital loss of $25,000 (Investment B). Your $25,000 loss would offset the full $20,000 gain from Investment A, meaning you’d owe no taxes on the gain, and you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years. Assuming you’re subject to a 35% marginal tax rate, the overall tax benefit of harvesting those losses could be as much as $8,050. Let’s take a look at how this works.

Using an investment loss to lower your capital-gains tax

By offsetting the capital gains of Investment A with your capital loss of Investment B, you could potentially save $7,000 on taxes ($20,000 × 35%). Because you lost $5,000 more than you gained ($25,000 – $20,000), you can reduce your ordinary income by $3,000, potentially lowering your tax liability an additional $1,050 ($3,000 × 35%) for a total savings of $8,050 ($7,000 + $1,050). You could then apply the remaining $2,000 of your capital loss from Investment B ($5,000 – $3,000) to gains or income the following tax year.

Issues to consider before utilizing tax-loss harvesting

As with any tax-related topic, there are rules and limitations:

  • Tax-loss harvesting isn’t useful in retirement accounts, such as a 401(k) or an IRA, because you can’t deduct the losses generated in a tax-deferred account.
  • There are restrictions on using specific types of losses to offset certain gains. A long-term loss would first be applied to a long-term gain, and a short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type.
  • When conducting these types of transactions, you should also be aware of the wash-sale rule, which states that if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes.

Even if you don’t have capital gains to offset, tax-loss harvesting could still help you reduce your income tax liability.

Let’s say Sofia, a single income-tax filer, holds XYZ stock. She originally purchased it for $10,000, but it’s now worth only $7,000. She could sell those holdings and take a $3,000 loss. Then, she could use the proceeds to buy shares of ZYY stock (a similar but not substantially identical stock) after determining that it’s as good as or better than XYZ, given her overall investment goals and objectives.

Sofia could use the $3,000 capital loss from XYZ to reduce her taxable income for the current year. If her combined marginal tax rate is 30%, she could receive a current income tax benefit of up to $900 ($3,000 × 30%). She could then turn around and invest her tax savings back in the market. If she assumes an average annual return of 6%, reinvesting $900 each year could potentially amount to approximately $35,000 after 20 years.

Harvesting losses regularly and proactively—when you rebalance your portfolio, for instance— can save you money over the long run, effectively boosting your after-tax return.

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