Understanding Tax Loss Harvesting
Our ability to help you reach your goals involves more than managing your investments and guiding you through challenging times. It encompasses many aspects of your financial situation, including tax management. While down markets are unwelcome, they provide opportunities to use trading strategies to add to after-tax returns. Strategies like Tax Loss Harvesting.
Tax loss harvesting is a confusing yet valuable tool we use to shift your taxes into the future and increase your long-term wealth. It is a strategy we employ in taxable accounts to lower your taxes. Note that IRAs and 401(k)s are not taxable accounts.
In essence, if your portfolio is a field of wheat, then every December we go through and pull up the weeds.
It’s important to understand the rationale because from the outside it just looks like we’ve planted you a crop of weeds. When you sell a stock or mutual fund, you realize a gain or loss. When you realize a gain, you owe taxes. When you realize a loss, you can use that loss to offset realized gains. If your losses exceed your gains, then you can reduce taxable income (up to $3000). You can bank any realized loss that remains for future years, either to offset future realized gains or taxable income.
So, if an investment’s value is lower than its cost basis, we can sell the investment, realize a capital loss, and use the sale proceeds to buy a similar investment. The result is a similar investment profile plus a capital loss you can apply on that year’s tax return.
On your tax return, you add realized gains and capital gain distributions and subtract capital losses. The total leaves you in one of three categories:
1. A year-end gain. Here, you will owe taxes. The federal tax code applies a lower tax rate to capital gains than to ordinary income. Most pay federal taxes of 15% on gains plus state taxes.
2. A year-end loss between $0 and $3,000. You are annually allowed to offset up to $3,000 of ordinary income with capital losses. Because your personal income tax bracket is higher than your capital gains tax bracket, it’s beneficial to apply capital losses against ordinary income.
3. A year-end loss > $3,000. After you use the $3,000 against ordinary income, any leftover losses can be banked for future tax returns. You will file a Tax Loss Carryforward to preserve these losses. In future years, you will apply the banked losses against capital gains.
One wrinkle is where to put the proceeds of the funds we sell? The IRS has a “wash-sale rule” that prohibits realizing losses when you buy a substantially identical asset within 30 days. For some funds we sold, we identified a similar fund that we are comfortable holding long-term. For other funds we sold, we moved money to a low-cost index fund to keep asset class exposure consistent, and then we will rebuy the old fund after 30 days.
Tax loss harvesting is one way we can be constructive when confronted with a down market.
Please let us know if you would like us to walk you through the harvesting we did in your taxable account. We also are able to communicate directly with your accountant if that would be helpful.
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