Posted by Fred Lake

Everything You Need To Know About Tax-Loss Harvesting

Everything You Need To Know About Tax-Loss Harvesting

It is indeed a very frustrating circumstance for investors when the stock market goes down. But amidst this gloomy situation, here comes an upside strategy which will increase your overall returns especially in your earlier years of investing; this is called the Tax-loss Harvesting.

Tax-loss harvesting: How does it work? 

In the current U.S tax law, offsetting your capital gains with capital losses you’ve incurred during the year and carrying over from a prior tax return is naturally made possible. Capital gains generally are the profits you realize when you sell an investment more than you paid for it; wherein the losses you realize when you sell an investment for less than you paid for it is considered as capital losses.

Since the taxes of U.S. investors is based on their capital gains, offsetting is a better way to lower your tax bill (as if you’re a U.S. investor). For instance, selling Fund A would give you an earning profit of $30,000 however in Fund B you notice that profit is down by $15,000. If you sell Fund B, you’d only end up paying taxes on the $15,000 profit instead of the $30,000. Meaning, you can use those losses to partially offset your gains from Fund A.

In this case, “harvesting” that $15,000 loss would have no effect on your portfolio’s value and your proceeds could be used to buy a similar investment. In this way, you can maintain the same asset allocation while reducing your federal income taxes at the same time, leaving you with the additional funds that would remain in your investment account continuing to earn investment gains.

In each year, your losses don’t just offset your gains but they can also offset up to $3,000 of your ordinary income. For instance, you realized that you still earn a profit of $30,000 from Fund A but lost 33,000 from Fund B and assuming that you had no other capital gains for the year, you can simply use your loss to offset your entire gain from Security A. Furthermore, you can reduce your income tax bill or increase your refund by deducting $3,000 from your ordinary income.

One thing to watch out for: Wash Sales

Selling or trading stock or securities at a loss and buying an identical to it within 30 days before or after the sale, is absolutely considered as “wash sale”. Therefore, you need to make sure that you don’t casually participate in it. And in order to prevent people from gaming the system, the IRS rule is put into place. In this, it says that you can’t just sell Security B and then immediately buy it back again just to get the tax benefit, because if you do so, thus the loss will be disallowed. If you buy another one in the same industry after you sell one stock, you are however allowed to claim the loss. The IRS would consider “substantially identical” to that which was sold but just not stock in the same exact company as before or in another investment.

Short-term capital gains

People to invest for the long-term rather than constantly buying and selling on ephemeral news receive more incentives from the government. It does so by taxing a higher rate in short-term capital gain (profits made from selling investments held less than a year) than long-term capital gains (profits from investments held longer than a year). This can have a particularly high impact on your tax bill to offset short term investments gains with losses to the extent possible. Tax-loss harvesting, in other words, can make a bigger difference if you trade a lot, or have invested in strategies that see higher turnover and thus more short-term gains. Up to whether particular capital losses offset short –versus long-term capital gains, take note that certain rules dictate on it.

A strategy called tax-loss harvesting is based on an opportunity created by tax law and not on market speculation. After all, tax returns could be greatly enhanced in some cases. This will put the investor well on the road to quicker asset accumulation. So, the next time the market turns downward, don’t feel blue. Take note! As to whether tax-loss harvesting will achieve any particular tax result or if it’s necessarily the best thing for you, well...there’s no guarantee in it. But be sure to check with your accountant or other U.S. tax advisor before implementing any tax strategy.

Fred Lake
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