Let’s face it – when you are investing in the stock market and it goes down – it’s not only a bummer but it’s frustrating as well.
But there is the proverbial “silk pouch from a sow’s ear” from an otherwise depressing situation – the ability to increases your after-tax returns through something called “tax loss harvesting”
Using tax loss harvesting you can indirectly increase your returns from investments especially early in the life of your portfolio.
In this article we will look at what tax loss harvesting is and how to use it to maximize wealth.
What is Tax Loss Harvesting?
So what exactly is tax loss harvesting?
Tax loss harvesting is a technique whereby you use the loss you may have had with an investment to offset your yearly income and therefore reduce your tax liability.
You can also use tax loss harvesting as a strategy to sell securities at a loss to offset a capital gains tax liability.
The latter is usually done to limit short-term capital gains which are taxed at a higher federal rate than long term capital gains, though it can be done for those as well.
Tax loss harvesting is usually done near the end of the calendar year but it can be done any time throughout the year. In fact, the roboadvisor Wealthfront will do this automatically when it sees the opportunity for you.
With tax loss harvesting, once the asset is sold to offset gains with the loss you then replaced with a very similar asset class to maintain your portfolio's balance.
Tax Loss Harvesting Example
Let’s look at a simplistic example of tax loss harvesting.
In our example you make $100k annual income and you have made $5000 from some of your investments.
So at this point your adjusted gross income that you could be taxed on is $105k.
However during the year some of your other investments don’t pan out and you end up losing $2000.
Now you can deduct that $2000 loss from your $5000 investment gain and your taxable gross income will be $103k.
Let’s look at this in another way as well.
Say that instead of losing $2000 you lose $6000.
Well now your loss cancels out your gain and you actually lose and additional $1000. You can deduct this loss and your adjusted gross income is now at $99k
Tax Loss Harvesting Limitations
There are some limitations to tax loss harvesting.
IRS Regulations on Tax Loss Harvesting
The IRS won’t let you buy and sell an assets simply to pay less in tax.
On your 1040 tax form Schedule D of the 1040 tax form, a loss will be disallowed if the same or substantially identical asset is purchased within 30 days.
This rule is called the “wash-sale rule.”
To counter this buy a similar asset that has a high correlation – but not substantially identical – to keep your portfolio balanced if you don’t want to wait the 30 days.
Tax Loss Harvesting Costs
Tax preparation can become a nightmare if you transact every time the market takes a plunge.
The general rule to follow is that if the tax benefit outweighs the admin cost then harvest the loss.
Growing Portfolios and Tax Loss Harvesting
Realizing your tax loss lowers your tax basis. This makes harvesting harder to do as your portfolio grows. However when you consider the time value of money it is always better to receive a tax benefit up front.
Through tax loss harvesting investors take a more active role in managing their portfolios.
You may actual even greatly enhance your after-tax returns that enables quicker asset accumulation that will make you more resistant to market downturns.
Are you planning on harvesting any losses this year? If so, what are they and how have things worked out for you?