7-minute read
Did you know that you can sell your low-priced securities, realize losses, and offset your capital gain tax liability with the losses? The exercise stands as tax loss harvesting.
Even though some assets lose value, they still hold the potential to become profitable in the future. So, you can sell them now and replace them with similar assets later. Selling such assets helps you to use their loss to reduce your existing tax liability on your capital gains.
How tax loss harvesting works?
Also known as tax-loss selling, the tax loss harvesting commonly takes place before a calendar year ends. However, it can take place any time of the year.
You can identify an asset that has unrealized losses from your portfolio. If you sell the investment at a loss, then the loss offsets any capital gain in your portfolio.
Afterward, you can replace the same security to maintain your portfolio asset allocation, return, and expected risk levels. You can opt to use the proceeds from the previous sale to replace the asset.
The exercise reduces the value of the loss. However, it does not help you restore your previous position. Tax-loss selling allows you to reduce the tax liability from an increment in the price of one of your high-performing portfolio assets.
Did you know that short-term capital gains attract a higher tax rate (37%-40.8%) than long-term capital gains? Short-term gains are from assets that are 1-year-old or less while long-term gains are for the assets that are over 1-year-old.
If you employ the tax-loss selling exercise, you will reduce the high tax liability from the short-term capital gains.
If the existing gains are long term and you have realized short-term losses, then you can consider paying the taxes on long-term gains. Hold on to the short-term losses for future use. The strategy will cushion you against paying high taxes after selling short-term assets in the future. You will use the tax savings to offset the short-term capital gains.
Not only does the exercise reduce your capital gains tax liability but also your federal income taxes. You can use up to $3k to offset your income taxes in one year.
If you did not use your investment losses after a sale, then you can carry forward them indefinitely. What you need is tax savings account to record the losses. Whenever any capital gain or federal income tax becomes due in the future, you can use the losses to offset the liabilities.
As a tax code, you should use the losses to offset the tax liability of similar assets first. If there is an excess loss, then you can use it on other assets.
Selecting the securities to sell
If you are interested in benefiting from the tax-loss selling, then you need to make a careful selection of your assets for disposal.
You should select assets that do not match your portfolio performance strategy. Assets that do not have healthy prospects for future growth and ones that you can replace easily also pass for disposal.
Avoiding a "wash sale"
The wash sale rule states that when purchasing a substantially identical asset, you should wait for 30 days after the disposal of the loss-generating asset. It is an IRS regulation.
If you buy a substantially similar asset before the lapse of 30 days, then you cannot use its capital losses to offset any capital gains.
Employees that receive stock-like bonuses should also check whether the vesting date falls in the 30-day window. The strategy comes in handy when capitalizing on tax loss to avoid a surplus accumulation of stock-based bonuses.
What is a substantially identical asset? The law does not provide a definition. So, you can buy a similar asset that has a different maturity date and interest rate. However, you cannot buy an asset that has similar voting rights with the disposed asset.
One way to avoid a wash sale entails purchasing an exchange-traded fund or mutual fund from the same industry with the sold stock. You should avoid selling assets that are hard to replace.
Maximizing the value of your tax loss
Making tax loss harvesting part of your year-round investing and tax-planning strategy maximizes the value of your tax loss. You should seek to build your investment portfolio while having a tax loss strategy in mind.
Instead of focusing on large fund caps, concentrate on individual investment pieces to create tax efficiency. Conducting periodic rebalancing of your portfolio will help you identify the lagging investments that are ideal tax-loss selling candidates.
Selecting an ideal cost-basis method
The cost of an asset refers to the buying price of an asset plus brokerage costs and commissions. You can opt to use a per-share average (average-cost method) or the actual cost of each share lot (actual cost method) to calculate the cost.
If you use the actual cost method, then you can target the high-cost share for disposal. The strategy helps you to realize high losses of the non-performing assets.
Prioritize investment goals
Capital losses are tempting for tax reasons. They can derail you from focusing on your investment goals. You require a balanced strategy that undergoes frequent re-evaluation to ensure that you gain optimally from the two approaches.
Summary
You can use the tax loss harvesting to minimize your capital gains tax liability. The loss also reduces your federal income tax where admissible.
A successful portfolio management balances between the achievement of the investment goals and reducing tax liability. If you have any doubts on how to undertake the harvesting, you should contact your tax advisor.
Footnotes
https://www.fidelity.com/viewpoints/personal-finance/tax-loss-harvesting