Tax loss harvesting is something that newcomers to the investing world often hear, but don’t quite think about. However, investing is all about putting your money to use in order to make more money. If you’re losing money on taxes, well, that’s defeating the purpose, isn’t it? The good news is that there’s a way to use losses from your investing activities to dampen down your tax costs. These are called tax loss harvesting strategies.
What Is Tax Loss Harvesting?
Tax loss harvesting is a process by which investors use investment-related losses to offset both investment-related and non-investment-related gains.
How Tax Loss Harvesting Works
Tax loss harvesting is a relatively simple process. Essentially, instead of simply reporting investment gains, losses are reported as well when it comes time to file your taxes. From there, the losses are deducted from the gains generated in the market that year. In some cases, losses will outweigh gains. In these cases, it is possible to use market losses to offset general income that would be reported on your taxes. Here’s how it works:
For this example, let’s say that you have investments in the retail sector that aren’t doing well. You also have investments in the technology sector that are performing better than you could have expected. So, you decide to take some time to balance your portfolio.
In the balancing process, you sell off some of the high earning tech stocks for a profit, racking it $15,000 in investment-related gains. Then you sell the worst performing retail shares that you own, bringing home a loss of $20,000. You continue to balance your portfolio by purchasing new shares and getting your allocation where you want it to be.
When it comes time to file taxes, you will have $20,000 in investment-related losses that can be harvested. In this particular case, the $20,000 lost in the retail sector far outweighs the $15,000 gained in the technology sector. So, your taxable gains are wiped out and you pay absolutely no taxes on the technology sector gains. So, where’s the other $5,000 go?
Well, current tax laws allow you to apply this loss to your income. However, you can only apply $3,000 in investment related losses to your income taxes per year. So, let’s say that you make $80,000 per year. Once you apply the $3,000 in tax loss harvesting funds to the mix, you only have to pay income taxes on $77,000 of that income.
That still leaves $2,000 from your original $20,000 loss in the retail sector. This $2,000 would be carried over to the next year and would be able to be harvested either against investment-related gains or general income.
A Few Rules To Consider
There are a few rules that should be considered when it comes to tax loss harvesting. First and foremost, retirement accounts like 401(k) and IRA accounts are off limits. The accounts are tax-deferred and cannot be deducted. It’s also worth mentioning that losses and gains must match in a way. A long-term loss would first be applied to a long-term gain while a short-term loss would be applied to a short-term gain. If there is excess in either of the categories, the excess losses can be applied to a gain of either type or to income reported. Finally, it’s important to keep in mind that if you sell a security at a loss and purchase that security within 30 days before or after the sale, the loss will not be able to be used for tax loss harvesting.
Taking a loss in the market can be a painful experience. No matter what stage of the investing game you are in, it’s going to happen at some point. However, as investors, we don’t have to just eat those losses and move on to the next trade. Through various tax-loss harvesting strategies, we have the ability to turn those losses into a positive when it comes to filing our taxes each and every year. So, don’t let money fly out of the window. Harvest your losses to make your tax burdens shrink!