Even with the market near all-time highs, not every investment will be a winner. If you own a diversified portfolio, you may have some losers. Fortunately, you may be able to use this loss to lower your tax liability or potentially offset some of your gains. This strategy is called tax loss harvesting and it is commonly used near the end of the year.
Tax loss harvesting is selling an investment at a loss to offset capital gains or ordinary income taxes. For example, suppose you invest $10,000 in XYZ stock. Let’s say this stock doubles and a few years later you sell it for $20,000, you would then have a $10,000 capital gain. If you were in the 15% long term capital gains tax bracket you owe the IRS $1,500. However, if you could sell enough assets to generate $10,000 in losses, this would negate your $1,500 tax bill.
Now that you know what tax loss harvesting is, let’s look at some ways it could save you money.
1. Ordinary Income Deduction
If you have more capital losses than gains, you may be able to use up to $3,000 a year to offset ordinary income and carry over the rest to future years.
Let’s say Brody, a single income tax filer, holds ABC stock. He originally purchased it for $10,000 and now it’s worth $7,000. He could sell his ABC stock and take a $3,000 loss.
He could then use the $3,000 loss to reduce his taxable income for the year. If his income for the year was $100,000, after the $3,000 loss his taxable income would be only $97,000. By doing this, he could be saving $900 in taxes (assuming he is in the 30% tax bracket: $3,000 x 30% = $900).
If Brody was a savvy investor, he could continue to invest in the market by using the proceeds of his sale to buy shares of a similar but not substantially identical investment.
An example of this would be selling a technology ETF (exchange traded fund) from one provider and then immediately buying a technology fund from a different provider. Both would have similar returns but are not “substantially identical”. This would allow you to continue to be invested in the same sector of the market.
2. Deferring Taxes into the Future
You can use tax loss harvesting to defer paying taxes until the future. This is useful when you have a relatively high income and expect to have a lower income when spending down your taxable assets during retirement.
When capital gains are offset by a loss on another investment, taxes are postponed until the replacement investment is sold later. Tax deferral allows for more of one’s portfolio to be invested where it can potentially grow and compound longer.
Although taxes are normally due later, if your income is low you may not owe any at all. There is a 0% capital gains tax rate for single filers making less than $40,400 and married fillers making less than $80,800. Common ways people take advantage of the lower tax bracket is when they lose their job or during retirement when their income is low.
3. Passing No Taxes to Heirs
One of the benefits of tax loss harvesting is deferring your taxes to no one. As great as that sounds, the only way to do that is by passing away.
This is called the “stepped up basis”. This rule says that your cost basis resets to whatever the value of your asset was on the day of your death. So unrealized gains or losses will be wiped out upon your passing. Meaning you could pass down your stocks, bonds, real estate etc. without any tax at the federal level.
So if you bought XYZ stock at $10/share and the day you passed it was worth $50/share, your beneficiary would inherit the $50 cost basis.
By combining tax loss harvesting with the stepped-up basis rule, you don’t just defer taxes, you avoid them all together.
Rules
Wash sale – A wash sale occurs when an investor sells or trades a security at a loss, and within 30 days before or after the sale you:
- Buy substantially identical stock or securities,
- Acquire substantially identical stock or securities in a fully taxable trade,
- Acquire a contract or option to buy substantially identical stock or securities, or
- Acquire substantially identical stock for your individual retirement arrangement (IRA) or Roth IRA.
Loses from wash sales are not deductible in most cases.
Max Capital Loss – The max capital loss deduction is $3,000 per year ($1,500 for a married individual filing separately). However, if capital losses are more than $3,000, it will be carried forward to future tax years.
Taxable account – Tax loss harvesting only applies to taxable accounts. There is no tax benefit for selling for a loss or gain in a retirement account.
Short Term Capital Gains – Profits from selling an asset that you have held for less than a year is considered a short-term capital gain. These gains are taxed as ordinary income, which is your personal income tax rate.
Bottom Line
Tax-loss harvesting is a strategy that can help investors minimize any taxes they may owe. The tax code is always subject to change and it’s important to review the current rules or seek help from a professional before making changes.
As always, if you have any questions, please email me at george@pmgwealth.com
George Maroudas
847-550-6100
george@pmgwealth.com
Twitter @ChicagoAdvisor
Disclaimers and Sources:
IRS Capital Gains and Loses: Link here
Investopedia Tax Loss Harvesting: Link here
What is the long-term capital gains tax: Link here
Capital Gains Calculator: Link here
Please consult your financial advisor regarding your specific situation. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. Stocks investing involves risk including loss of principal. Rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs, and when rebalancing a nonretirement account, taxable events may be created that may affect your tax liability.
