Tax-Loss Harvesting can reduce your tax bill and increase the tax-efficiency of your portfolio.

9/27/2022 by Ayad Amary

 

Tax-Loss harvesting is a strategy that is designed to effectively use losses in your non-retirement accounts to increase the overall tax efficiency of your portfolio and financial plan. In general, it involves selling an investment at a loss and replacing it with a similar investment within the same asset class and sub-asset class.

 

This strategy is most often used to reduce the amount of taxes due on short-term capital gains, which are generally taxed at a higher rate than long-term capital gains. However, you may also offset long-term capital gains with this same tactic.

 

The idea here is to “bank” the capital loss of the unprofitable investment to offset any capital gains made throughout the year while at the same time preserving the value of the investor’s portfolio.  The by-product of such strategy should be a lower tax-bill on your investment portfolio.

 

In addition to offsetting any capital gains, you can take a net loss of up to $3,000.00 in any one given tax year and write it off against your ordinary income.  If you have greater than a $3000.00 net loss, you can carry forward that loss to the following tax year and use it accordingly to offset more gains or continue to deduct against future ordinary income at the same $3000.00 annual limit.

 

A few important considerations if you are attempting to apply this strategy on your own:

 

  • Long term capital losses can only be used to offset long term capital gains. Likewise, short-term losses can only be used to offset short term gains.
  • Be sure you are not violating the IRS Wash Sale Rule which is defined as selling and purchasing the same security withing 30 days. In other words, you must replace the unprofitable security with a security that is deemed not “substantially identical” (A “substantially identical security” is defined as a derivative contract, such as a call option, issued on the same underlying security or a security issued by the same company (e.g. same investment but different share class)
  • This strategy is only useful in taxable accounts so it should not be employed in IRAs, 401k, or other tax deferred/tax-free accounts.
  • You should replace your losing investment as soon as it is sold to avoid your allocation being under-represented in that particular asset class.
  • Always be sure any strategy you implement makes sense in relationship to your long term financial plan.

 

The Bottom Line

Although tax-loss harvesting can be done at any time throughout the year, most portfolio managers wait until the fourth quarter as they assess year-end performance and make decisions about which holdings to maintain. If used appropriately, tax-loss harvesting can be a powerful strategy in reducing your tax liability without negatively impacting the long-term performance of your portfolio.

Disclaimer

This article is intended for informational purposes only, and should not be considered financial, investment, business, tax, or legal advice. You should consult a relevant professional before making any major decisions.

9/27/2022 by Ayad Amary

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