Reducing your taxes is a goal for many individuals, especially when investing in stocks or other assets. One effective strategy to consider is tax-loss harvesting.
What is tax-loss harvesting?
Tax-loss harvesting is a strategy where you sell investments that have declined in value to offset your gains. This means that when you sell an asset at a loss, you can use that loss to reduce the amount of capital gains that will be subject to tax from other investments. You can also apply these losses to offset up to $3,000 in ordinary income annually, and if your net capital loss is more than this limit, you can carry the loss forward to later years until death.
How does it work?
Sell a losing investment
You identify an investment (e.g., stocks, bonds, mutual funds) that has decreased in value and sell it.
Offset capital gains
The loss from this sale can be used to offset any gains you’ve made from selling other investments that have appreciated in value. For example, if you made $10,000 in profits on one stock but lost $4,000 on another, you can use the loss to reduce your taxable gain to $6,000.
Ordering rules
There are ordering rules when you have both long- and short-term capital gains and losses. In simple terms, you will first offset your short-term losses versus your short-term gains and then your long-term losses versus your long-term gains. Any excess you have between the two categories can then be further offset against one another.
Capital loss and carryover limits
If your capital losses exceed your capital gains after netting, you can deduct the lesser of $3,000 ($1,500 if married filing separately) or your total net loss against your ordinary income. If your total net loss is more than $3,000, you can carry forward those losses into future years until death.
Reinvest carefully
After selling a losing investment, some investors may want to stay in the market. However, be cautious of the IRS’s wash-sale rule, which prevents you from buying a “substantially identical” security within 30 days before or after the sale. Violating this rule will disallow the current tax benefit from the loss.
Example of tax-loss harvesting
Imagine you own two stocks. Stock A has gained $5,000 in value, while Stock B has lost $3,000. If you sell Stock A, you would normally have to pay taxes on the $5,000 gain. However, if you also sell Stock B at a $3,000 loss, you can subtract the $3,000 loss from the $5,000 gain. This means you would only be taxed on $2,000, potentially saving hundreds of dollars in taxes.
Tax-loss harvesting can be a valuable tool to reduce your tax burden, especially in years with volatile markets. However, always consult with a tax professional and Wealth Advisor to ensure you’re making the best decisions for your individual financial situation.