Investments

How Does Tax Loss Harvesting Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

Even if you stick to mutual funds and exchange-traded funds, investing may be a hassle (ETFs). It takes time and effort to determine the appropriate asset allocation, select the most suitable assets, track performance, and rebalance a portfolio.

An expert investor can use tax-loss harvesting to minimize their tax liability. Even if it’s difficult to understand, it could be beneficial for those in higher tax brackets to have a look at this.

How Does Tax-Loss Harvesting Work?

The advanced tax and investing approach is known as “tax-loss harvesting” and involves selling assets at a loss in order to claim a write-off for those losses. It may seem paradoxical to sell investments at a loss. 

However, the plan is to re-invest the money in other assets that will provide a similar rate of return. The idea is to secure a capital loss in exchange for a current tax benefit without negatively affecting the long-term performance of the portfolio.

The Process of Tax-Loss Harvesting

Selling a losing venture and reinvesting the proceeds in a more promising one is the bare bones of tax-loss harvesting. This will result in a capital loss that can be deducted from your taxes while yet allowing you to hold onto your money in the market.

Instead of taking money out of poor investments and putting it into winning ones, advanced techniques try to help you lock in losses while maintaining your money invested in a similar fashion. However, according to the wash sale requirement, merely selling and repurchasing the same security isn’t sufficient more on this shortly.

Tax-Loss Harvesting Example

Let’s say you invested $500 in 100 shares of XYZ and now you own 10 shares. The current price of XYZ is $40 per share.

You decide to engage in tax loss harvesting and thus sell your XYZ shares for $4,000. You realize a $1,000 capital loss on the sale. Afterward, you invest the additional $4,000 in a different stock or mutual fund.

If you’ve sold any investments for a profit this year, or expect to sell investments for a profit later in the year, you can deduct $1,000 from your earnings before having to pay any capital gains tax, according to the provision in the tax code that permits capital losses to offset capital gains.

There are alternatives to using capital gains as a tax deduction if you don’t have any. Capital losses can be used to reduce other types of income, up to a certain threshold. Investment losses can only be used to reduce taxable income up to $3,000.

Picture this you’ve incurred a $1,000 capital loss similar to the one we used above but you have no capital gains to use as a counterbalance. With a $1,000 deduction, your taxable income for the year drops from $40,000 to $39,000.

Rule of the Wash Sale

The wash sale rule is crucial in the context of tax-loss harvesting. You cannot incur a capital loss by selling the investment and then repurchasing the same investment within 30 days. In the event of a wash sale, you will not be able to deduct any of the capital loss from your taxable income.

If you sold XYZ shares at a loss and then repurchased them the following day, the transaction would be considered a wash sale, and you would not be able to deduct the loss from your capital gains.

Buying substantially identical security within 30 days of making a loss on another transaction is considered a wash sale.

Multiple securities are extremely similar. Typically, this refers to mutual funds. It is possible for multiple funds to follow the same stock index or industry sector but are managed by separate companies. 

To sum up, exchange-traded funds (ETFs) and mutual funds (MFs) are likely to be significantly similar if you may use them interchangeably in your portfolio. Two popular ETFs that follow the S&P 500 are VOO and SPY. They are so similar that they are probably interchangeable.

One of the obstacles to tax-loss harvesting for individuals is the wash sale regulation. Maintaining a predetermined asset allocation is essential if you want to retain the bulk of your savings invested in the market. While tax-loss harvesting, the wash-sale rule may prevent you from making some investments for a while.

Cost-Based Calculations

If you want to reap the benefits of tax-loss harvesting, you need to have a firm grasp on the idea of cost basis. The investment cost basis is the original purchase price. Your cost basis for a single share of XYZ stock you purchase for $50 is $50. If you spend $5,000 to purchase 100 shares, your cost basis for each share is $50.

To calculate your capital gain or loss on the sale of an investment, subtract the sale price from the cost basis. If you bought XYZ stock for $50 and sold it for $60, your profit would be $10. A capital loss of $20 results from selling something worth $50 for $30.

When purchasing security many times at different prices, things can get tricky. If you gradually build up your portfolio over time, you might eventually hold 100 shares of XYZ, for instance.

  • A purchase of 20 shares at $50 each
  • A purchase of 15 shares at $45 each
  • A purchase of 10 shares at $47.50 each
  • A purchase of 5 shares at $52 each
  • A purchase of 50 shares at $43 each

You can keep tabs on your cost basis in one of two ways: either by keeping note of the basis for each share individually or by averaging the prices paid. When keeping tabs on a mutual fund’s cost basis, the average price is a typical choice. Cost basis is also something most brokerages keep tabs on.

In order to produce investment losses for the purposes of tax loss harvesting, the stock must be sold at a price lower than its initial cost basis. As a result, cost-basis tracking is crucial for tax-loss harvesting.

Advantages and Disadvantages of Tax Loss Harvesting

You can lower the amount of income tax you owe by using tax loss harvesting. Despite the tax savings it provides, this method is difficult to put into practice and, in many cases, essentially trades off lower taxes now for greater ones later.

Advantages

Tax-loss harvesting is attractive to certain investors because it provides tax advantages that may be used to offset tax on investment profits and regular income.

  1. Reduce Taxes Paid on Capital Gains. With tax-loss harvesting, you can record capital losses that cancel out capital gains at a rate of one loss for every one gain. This might be a huge tax break if you have a lot of money coming in from investments or capital gains.
  2. Minimize Regular Income. It is possible to offset up to $3,000 of annual taxable income with capital losses. This can be significant savings in terms of taxes owed if you’re in a high tax rate.
  3. Unlimited Carry-Over. Only capital losses can be used to offset capital gains and up to $3,000 in ordinary income. If your losses for the year are higher than your deductions, you can roll them over to the next tax year. Any losses incurred through a tax-loss harvesting approach can be carried forward indefinitely, allowing you to enjoy the tax benefits for as long as possible.

Disadvantages

There are disadvantages to using tax loss harvesting. It’s not only complicated and tricky to implement without breaking any IRS laws, but it also could not lower your tax liability as much as you anticipate.

  1. It’s Not Easy to Recover Past Tax Losses. The wash sale rule prevents instantly buying back sold investments. You should diversify your investments and never buy the same kind of investment twice in a 30-day period. In practice, it may be challenging to keep your asset allocation in line with these guidelines.
  2. Valid Only for Accounts Subject To Taxation. Reducing your taxable income is the main goal of tax-loss harvesting strategies. Because capital gains taxes aren’t levied on IRAs and similar tax-deferred accounts, you can’t employ this technique if that’s where you do most of your investment.
  3. Reduced Your Cost Basis To. Reducing the cost basis of the assets in your portfolio is the primary effect of tax-loss harvesting. Your taxes will go down right away due to your realized losses, but if your investment goes up in value and you sell it, your realized profits and taxes could be considerably larger.
  4. Taxes Paid Both Short-Term and Long-Term are affected by frequent sales. The tax rate on long-term capital gains is significantly lower than that on short-term gains. In order to receive the long-term rate, a security must be held for a minimum of 12 months before sale. Short-term gains will certainly outweigh long-term gains if you sell and buy stocks regularly to take advantage of tax losses.

Use of Tax Loss Harvesting Is Recommended

Investors who are looking to minimize their tax liability may find tax-loss harvesting to be an attractive strategy; nevertheless, the approach is typically too complex for an individual to apply successfully.

If you have a sizable amount of money in taxable accounts — say, $100,000 or more — you may want to give this some thought. A financial management firm or automated investment advisor Robo-advisor is always available for hire.

While tax-loss harvesting is an option for some, most investors are better suited to focusing on the long term and building a solid portfolio.

Bottom Line

The practice of tax-loss harvesting isn’t a must-have for the majority of investors. Offsetting gains in your portfolio is good, but unless you have a lot of money to invest, it’s not worth the hassle of applying this technique while still sticking to your asset allocation and IRS regulations.

Investing through tax-advantaged funds like a 401(k) or an Individual Retirement Account (IRA) can be a great method to save money on investment taxes.

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