Investing in properties, stocks, and other assets is a historically lucrative endeavor, offering potential significant gains over time. However, it’s easy to forget that your income from selling them is subject to capital gains tax that can factor into your overall ROI. Thus, it’s crucial to consider your investment’s tax implications before selling them.
Fortunately, there are strategies to mitigate tax impact on your portfolio/investments, one of which is tax loss harvesting. How does tax loss harvesting work? Let’s delve into its mechanics and how to leverage it to optimize your portfolio’s performance.
What is Tax Loss Harvesting? (And How Does It Work?)
Tax loss harvesting is an investment strategy designed to minimize your taxable income by selling underperforming assets, offsetting your gains from profitable investments. In effect, you turn investment setbacks into strategic tax advantages, maximizing your portfolio’s tax efficiency.
Let’s use an example. Say you have two stocks in your portfolio with this type of cost basis:
- Stock A with a $30,000 gain
- Stock B with a $50,000 loss
Without tax loss harvesting, you’d be liable for capital gains tax on Stock A’s gains. However, by selling Stock B and realizing the $50,000 loss, you offset Stock A’s capital gains, meaning you won’t have to pay capital gains taxes for Stock A. It gives you more control over when you incur capital gains taxes, potentially lowering your bill.
Currently, the IRS allows you to deduct up to $3,000 ($1,500 if married but filing separately) in net losses from your total net income. You can carry the loss forward to later years if your losses exceed this threshold.
Rules and Limitations of Tax Loss Harvesting
Understanding the following principles helps you lawfully maximize your investment gains and performance.
This wash-sale rule keeps you from exploiting tax loss harvesting by immediately buying back identical assets within 30 days before or after the sale, including purchasing an option or contract to buy the stock. Otherwise, the IRS could keep you from claiming the loss on your taxes in the current or future year.
Tax loss harvesting is only applicable to taxable investment accounts. Meanwhile, tax-deferred investments, like 401(k) or Individual Retirement Arrangements (IRAs), aren’t liable to taxes until you withdraw your money, so they don’t provide an immediate tax benefit. So, choose the accounts you want to balance wisely.
Capital gains matching
Short- and long-term investment gains have different tax rates. While matching your losses and gains can be effective in tax loss harvesting, the losses’ availability may not always align with your target gains. You should also consider the wash-sale rule when attempting to match gains and losses to avoid penalties.
How to Integrate Tax Loss Harvesting into Your Financial Plan
Incorporating the following practices into your financial plan can help improve your tax efficiency and position yourself for long-term financial success.
1. Review annual tax loss harvesting in your end-of-year strategy
Periodically review your portfolios to identify underperforming assets and consider the benefits of realizing the losses. Remember, you will likely want to buy another stock or fund after you sell the one with a loss. What if the market goes up while you own the next fund you are buying? (While you wait to be compliant with the wash-sale rule). The answer… you will either have to realize the loss or the gain in that stock or fund to get back to the original fund. The lesson here – realize that there are a host of factors that play into the decision to realize gains or losses and work with your financial planner to develop an intelligent plan.
2. Look closely at tax loss harvesting during a bear market
It’s crucial to prepare a strategy during a bear market. One strategy is selling underperforming assets allowing you to realize these losses and use them to offset capital gains from more successful investments. Bear markets are also an excellent opportunity to purchase securities (enter the market) at low prices.
3. Time when your tax bracket will change to maximize the harvest
Understanding your tax bracket will help you maximize tax loss harvesting. (That is why it is critical to be working with a group that is managing your assets, and is focused on tax consequences. Not very many firms are willing to allocate the time to look at both)! If you anticipate a change in your tax bracket you may strategically choose when to realize losses to leverage tax benefits. Remember that harvesting losses in the 0% bracket isn’t beneficial since investment gains aren’t taxable.
4. Coordinate tax loss harvesting with capital gains realization
Instead of simply offsetting gains, you can optimize tax outcomes by intentionally realizing gains with harvesting losses. In other words, it can be more beneficial to realize losses when you have significant gains and, likewise, realize gains during significant losses.
5. Make sure your stock options aren’t interacting with the wash-sale rule
Stock options complicate tax loss harvesting, especially when navigating the wash-sale rule, so navigate this consideration carefully to avoid unintended consequences. If you’re selling a stock with a loss and simultaneously purchasing a call option of the same stock within the wash-sale period, the IRS might consider it a violation.
6. Work with a financial advisor to create a comprehensive tax strategy
Maximizing tax loss harvesting requires thoroughly understanding your financial situation, goals and IRS rules. So, consider collaborating with a financial advisor. They can assess your overall financial picture, considering factors such as income, tax brackets, and long-term financial goals to develop an efficient investment strategy incorporating tax loss harvesting seamlessly.
Maximize Your Investment Returns with Tencap Wealth Coaching
Tax loss harvesting is a powerful tool for optimizing your investment outcomes amid the complexities of the tax landscape. However, it may be challenging to manage this strategy alone, so it’s important to have qualified help.
The best way to develop a tailored tax loss harvesting strategy is by talking to a financial advisor and tax strategist from a reputable organization like Tencap Wealth Coaching. Our investment planning and tax strategy services ensure you maximize your returns and enjoy a financially stable future.
Contact us to learn more!
Nick trains and develops families in creating, maintaining, and growing wealth. This includes educating clients on the science and academics of investing, comprehensive financial planning, and ongoing coaching to ensure discipline for a lifetime. Nick has seen this create incredible levels of freedom, fulfillment, and love for the families he works with.