Tax loss harvesting is selling some investments at a loss to offset other investment gains. You’re trying to keep your income tax down. Once you start playing the investing and trading game, you’re bound to lose money on some and make lots on others. Of course, we want to be in the latter boat. And if we’re incredibly savvy with our investments and trades, our boat is filled with gold, diamonds, cash, and all the otherworldly treasures money can buy. It’s time to go shopping!!!! Or is it? Don’t get excited yet. The taxman wants a piece for all those thousands of dollars in gains you made. Let me introduce you to the dreaded capital gains tax and how tax-loss harvesting can help avoid the taxman.
What Is A Capital Gain?
In order to understand tax loss harvesting, we need to know what defines capital gains. A capital gain is when you sell an investment or an asset for a profit. Unfortunately, the government considers these proceeds income and taxes; no surprise there.
Short vs. Long-Term Capital Gains Tax
The amount you owe in capital gains tax partly depends on how long you owned the asset. Long-term capital gains are from an asset you’ve held for more than one year.
Alternatively, short-term capital gains apply to profits from selling an asset you’ve held for less than a year.
The tax owed depends not only on the length of time you held the security but also on your marginal tax bracket. In some cases, that could mean you could pay up to 37% income tax, depending on your federal income tax bracket.
When You’re Boat Is Sinking
More often than not, I find myself on a sinking ship when it comes to trading. In fact, I know someone right now who’s in a trade about a million dollars in the wrong direction. Images of the titanic are conjuring up in my head -cringe.
But, there’s a bright side to this sinking ship. Let me introduce you to tax-loss harvesting.
What Is Tax Loss Harvesting
Tax-loss harvesting takes losing positions inside a portfolio and uses those to offset potential gains or realize gains that you already have.
In simple terms, you sell an investment worth less than what you bought it for. You then turn around and sell an investment worth more than what you bought it for. The loss on the one helps to offset the gains on the other.
The 5-Minute Take Away
- When you sell an investment or an asset for a profit, it’s considered a capital gain.
- You’ll owe capital gains tax if you have a capital gain on any investments/assets you sell
- You can use tax-loss harvesting to avoid capital gains tax
- You can only do tax-loss harvesting in your taxable brokerage accounts
A Real-Life Tax Loss Harvesting Example
Let’s say it’s December, and you made a profit throughout the year in your trading account. You silently thank Bullish Bears for their trading courses.
Undoubtedly, you don’t want to pay taxes. So how do you get around this? Well, the solution is quite simple:
Tax-loss harvesting. You can simply sell any amount of losing positions to offset the capital gains in your winning positions.
In fact, you can go into the negative and report as much as a $3000 capital loss on your taxes. If you have more than a $3000 capital gain and a $5000 loss, you can carry forward the additional dollars to subsequent tax years.
The IRS would allow you to claim $3000 of it this year, and they would let you use the other $2000 next year. Click here for additional details.
Rebalancing Your Portfolio
Tax-loss harvesting is a common approach for rebalancing portfolios. Let’s walk through an example. One Sunday afternoon, you decide to take a look at your portfolio. Upon closer examination, you notice the tech stocks you went heavy on have soared in value.
But, unfortunately, the healthcare stocks you have tanked. So, now your portfolio is overweight in tech stocks. However, because they’re so profitable, you want to sell some of them to lock in the profits.
So, you sell some of those tax stocks, realizing a taxable gain. But you’re savvy. You don’t want to pay any money to the taxman, so you sell some of your healthcare stocks, realizing a loss.
Next, you turn around and reinvest the proceeds in a way that balances your portfolio. And when tax time comes, the loss on the healthcare stocks offsets the gain on the tech stocks. As a result, you won’t owe any capital gains taxes.
As I mentioned above, the IRS allows you to use up to $3000 of the remaining capital loss to lower your taxable income. So in the example above, the final $2000 is carried forward and could be used to offset income in future tax years.
Tax Benefits Based On Your Marginal Tax Rate
Assuming you sit in the 35% marginal tax rate bracket, your overall tax benefit could be $8000.50. So even if you don’t have any capital gains to offset, any investment losses in the current tax year could reduce your taxable income by up to $3000. That’s pretty impressive if you ask me.
Tax Loss Harvesting Rules
It should come as no surprise that there are also some rules to keep in mind when dealing with the government. You can only do tax-loss harvesting in your taxable brokerage accounts – not in 401(k)s or IRAs.
Also, you have to use short-term losses to offset short-term gains and long-term losses to offset long-term gains. But, if you have excess losses in either category, they can be applied to either type of gain.
Beware of the 30 Day Rule
Finally, you can’t sell your security at a loss just to re-buy it at a bargain-basement price. You can as long as you wait 30 days before doing so. When you’re tax-loss harvesting, ensure that you’re reinvesting in other securities than the ones you’re using to book a loss.
Tax Loss Harvesting Final Thoughts
Be smart and you just might find yourself with a boatload of tax-free gold. Consult your tax or financial planning professional to see how tax-loss harvesting could fit into your tax or financial planning process picture.
Image and article originally from bullishbears.com. Read the original article here.