Tax loss harvesting may sound complicated, but it's actually a straightforward way to reduce your taxes and help keep your investments growing.
What Is Tax Loss Harvesting?
Tax loss harvesting is like a money-saving trick for your investments in accounts outside of IRAs. It involves selling investments that are down, and replacing them with similar investments, which can help lower the taxes you owe on your gains. The idea is to use these losses to offset any profits you've made in your investment portfolio, meaning less money goes to taxes and more can stay in your pocket working for you.
Two Ways Tax-Loss Harvesting can help manage taxes
Losses can be used to offset investment gains
Remaining losses can offset $3,000 of income on a tax return in one year. (For married individuals filing separately, the deduction is $1,500.)
The Benefits of Tax Loss Harvesting
Pay Less in Taxes: By using tax loss harvesting, you can pay less in taxes, leaving more money in your pocket.
Grow Your Investments: Lower taxes mean more money to invest, potentially leading to bigger returns over time.
Keep Your Investment Mix: You can do tax loss harvesting without completely changing your investments, so you stay on track with your financial goals.
Capital Gains in Mutual Funds vs ETFs
Capital gains can come in a couple different forms. If you’re invested in mutual funds, your capital gains may come from not only selling but also in the form of mutual fund distributions. This is when mutual fund companies pass through the gains from selling assets onto the shareholder. This can make tax planning a little tricky as you, the shareholder, do not have any control on when you get those gains.
However, ETFs are not subset to this same rule. ETFs are structured in a way that avoids the gain pass through to shareholders. This means that you are only paying capital gains tax when you sell something at a gain. This gives you a lot more flexibility when it comes to tax planning.
How to Do Tax Loss Harvesting
Find Losing Investments: Look for investments in your portfolio that are worth less than what you paid for them. These are the ones you can use for tax loss harvesting.
Follow the Rules: The IRS has some rules to follow. The most important one is to avoid buying the same investment or a “substantially identical” security within 30 days of selling a losing one. This is called the wash sale rule.
One way to avoid a wash sale on an individual stock, while still investing in the industry of the stock you sold at a loss, would be to consider substituting a mutual fund or an exchange-traded fund (ETF) that targets the same industry.
Offset Gains and Income: Use the losses you've made to lower your taxes on any profits you've earned. If your losses are more than your gains, you can even reduce your regular income, up to a certain limit set by the IRS.
Keep Your Investment Mix: After you've sold a losing investment, replace it with something similar that matches your overall investment plan.
Review Regularly: Tax loss harvesting isn't a one-time thing. Check your investments regularly to find chances to save on taxes and improve your portfolio.
Risks and Things to Keep in Mind
While tax loss harvesting is a great way to save money, there are a few things to be cautious about:
Market Timing: It can be tough to pick the perfect time to sell investments to lower your taxes. Don't let this strategy interfere with your long-term plan.
Follow the Rules: Always make sure you follow the IRS rules, especially the wash sale rule, or you might not get the tax benefits.
Extra Costs: Frequent trading can lead to more fees, which might eat into your returns.
Tax loss harvesting isn't as complicated as it may seem. It's a way to reduce your taxes and potentially increase your investment returns. By selling investments that aren't doing well, following some rules, and paying attention to your portfolio regularly you can keep more of your money and make it work harder for you. It's a simple but powerful strategy for smart investors.