Even though investment has lost value, it might still be beneficial—or at the very least, not as awful. Tax-loss harvesting is a strategy for turning a losing investment into a tax-profitable one. Tax-loss harvesting may be able to assist you in lowering your current and future taxes. Selling securities at a loss to offset a capital gains tax liability is tax-loss harvesting. This is a common method for limiting the recognition of short-term capital gains. Short-term capital gains are normally taxed at a higher rate than long-term capital gains at the federal level. On the other hand, the method may be used to offset long-term capital gains. You can use tax-loss harvesting to sell down investments, replace them with essentially comparable investments, and then offset realized investment gains with losses. As a result, you’ll lose less money to taxes and have more money to invest and work for you. Investors can recoup their losses by selling their failing assets and investing the money in similar ventures that may grow over time. These future gains can then be offset by future losses, creating a virtuous tax savings cycle. The sales proceeds can then be re-invested in assets similar to the ones sold, albeit IRS guidelines require investors to wait at least 30 days before purchasing another asset that is “essentially comparable” to the one sold at a loss tax-loss harvesting reasons.
Loss harvesting fundamentals
Consider this scenario: You’re analyzing your portfolio and notice that your tech assets have grown dramatically in value, while some of your industrial equities have declined. As a result, the IT sector now accounts for much too much of your portfolio’s worth. You sell certain tech stocks and utilize the proceeds to rebalance your investments to your preferred allocation. You’ll wind up with a substantial taxable gain as a result of the approach. Tax-loss harvesting is the most important strategy for many investors to lower taxes. Although tax-loss harvesting will not bring an investor back to their original position, it will help to mitigate the severity of the loss.
Tax-loss harvesting not only lowers your taxes but also frees up capital to invest in fresh assets that are more likely to perform well. To maintain your asset allocation and risk profile, you’ll probably want to purchase a similar type of investment. There are some guidelines to follow while making your next purchase. For example, you can’t sell a stock to incur a loss and lower your tax bill, then repurchase the same stock, or even one that’s virtually identical. A wash sale is the term for this maneuver. A wash sale occurs when you sell securities at a loss and then buy “essentially” identical securities, or gain a contract or option to do so, within 30 days after the sale. The IRS won’t let you claim the loss on your return if you sell a security at a loss and buy an asset that’s substantially comparable to it within 30 days before or after the sale. The wash-sale rules apply to all of your household’s accounts. If you sell a stock in your taxable account, you’ve broken the rule but then buy it again in your 401(k).
Things to consider before utilizing tax-loss harvesting
Because you can’t deduct losses created in a tax-deferred account, tax-loss harvesting isn’t effective in retirement accounts like a 401(k) or an IRA. There are limitations on how certain sorts of losses can be used to offset certain gains. A long-term loss would be applied on a long-term gain first, followed by a short-term loss on a short-term gain. If any losses are leftover from one category, they can be allocated to gains of any type.
Importance of Planning
You shouldn’t go alone when it comes to tax-loss harvesting. It’s part of a broader financial planning strategy. You and your advisor or accountant will need to understand your tax situation and rates for starters. These are crucial in determining whether or not selling your losers will benefit you. When you sell an investment that you’ve owned for less than a year, you’re either making a short-term profit or losing money. Short-term profits are taxed at the same rate as regular income, up to a maximum of 37%. If you need help with your taxation strategy, feel free to contact us.