Economic downturns can quickly cause losses to your precious investments. The current downfall due to coronavirus has reached every financial market so far. There can hardly be any positive outcomes from the economic turmoil for investors. However, you can use the tax-loss harvesting strategy to minimize your losses.
The Tax-loss harvesting strategy is primarily used to reduce the tax liability. It is used to match the losses in a few investments with capital gains in others. Since we are facing such a sluggish economic time, it’s inevitable to bear the brunt.
Let us guide you through the ins and outs of tax-loss harvesting. We’ll take you through some useful tips on how you can take advantage of market downturns for tax-loss harvesting.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a strategy in which investors sell some of the loss-making investments to offset the tax liability on capital gains of other investments.
The strategy is primarily used to lower the tax liability. Since capital gains are taxed higher, investors can use the losing investments to reduce the tax implication.
If done properly, these losses can be used to offset full or part of the tax liability on capital gains. The losses and capital gains can happen at the same time. However, investors can defer both capital gain profits and investment losses to match the effects later.
Tax-loss harvesting strategy requires careful analysis of investment portfolio. You may not find the capital gains and losing investments at the same time. Investors look for long-term capital gains but sometimes face losses on short-term investments. These losses can be carried forward to later at the time of capital gains.
Since tax-loss harvesting can involve several transactions of selling securities at losses, it can best be performed with the help of automatic trading. Some specialist firms also offer the tax-loss harvesting services as a featured service to their clients.
Tax-Loss Harvesting Rules to Know
Tax-loss harvesting is a legal strategy that many investors use these days. Although it isn’t a new investment strategy, it has come into the limelight in recent years. As an investor, you can take full advantage of the tax-loss harvesting strategy. However, you’ll need to follow certain rules to stay compliant with the federal income tax regulations.
Let us briefly discuss these important rules relating directly to tax-loss harvesting strategy.
Applicable on Taxable Accounts Only
Investors can use the tax-loss harvesting method to apply only taxable investment accounts. Long-term investment accounts such as IRAs and other retirement plans cannot be used for tax-loss harvesting. These accounts use deferred capital gains hence do not incur capital gains taxes.
You cannot offset the capital losses on security against the capital gains of the same security within 30 days. It is called the wash-sale rule. It is devised to control the misuse of the tax-loss harvesting strategy.
As an investor, you cannot buy or sell a security at loss, before and after 30 days of buying or selling the same security again. You cannot make such a transaction with the “identical” security as well. However, you can make a transaction with “similar” security.
The Wash-sale rule is a delicate one and should be implemented carefully. If you do not comply, all your tax write-off gains can be disallowed by the IRS.
Capital Gains Rule
Capital gains come through securities held for one year at least. Short-term gains are classified as securities held for less than one year.
An important rule with tax-loss harvesting is to match gains on securities of the same category.
- Capital gains are taxed at 0%, 15%, or 20% according to your tax bracket.
- Short-term gains are taxed according to your income slab as with other sources of income.
- You must off-set the long-term losses first against the long-term capital gains.
- You can then apply long-term gains against short-term losses.
- Lastly, you can utilize the short-term gains against the short-term losses.
When using tax-loss harvesting, care must be taken with the classification of securities and their tax brackets.
Tax-Loss Harvesting Threshold
The prime objective of tax-loss harvesting is minimizing the tax liability. However, you can claim a limited tax claim in a year. You can claim up to $3,000 of realized capital losses if you are filing jointly for taxes. Your tax claims will be $1,500 for single filing tax returns.
If you want to offset more gains against investment losses, you can carry forward the balance. You can take forward the investment losses to the following years as long as you have balance in losses.
Advantages of Tax-Loss Harvesting
Tax-loss harvesting can bring several advantages to investors. It can help minimize tax liability as well as balancing the investment portfolio.
Here are a few key benefits of the tax-loss harvesting strategy:
- Investors can harvest losses to potentially reduce the tax liability.
- If strategized properly, investors can fully remain invested with their investment planning after loss harvesting as well.
- You can use a tax-loss harvesting strategy to re balance your investment portfolio.
- Investors can carry forward their investment losses for later capital gains by deferring the loss realization.
- Investors can use capital losses to offset ordinary income up to the allowed limit as well.
Disadvantages of Tax-Loss Harvesting
Tax-loss harvesting can be an effective strategy to lower your tax liability and portfolio re balancing. However, it comes with a lot of sophisticated regulations. If you do not follow the regulatory instructions, you can be at a disadvantage as well.
Here are some key considerations with tax-loss harvesting strategy:
- You cannot break the wash-sale rule by offsetting capital gains and losses for the same security.
- It cannot provide substantial tax relief to investors having low-tax brackets since its prime objective is to lower the tax liability.
- It can be used with taxable investment accounts only.
- Investment losses above the threshold limit can only be taken forward as a tax deferment strategy.
- This strategy involves substantial administrative costs that can affect the realized net benefits.
- It requires multiple transactions that require precision and timely execution, hence often requires automation of trading strategy.
How to Use the Tax-Loss Harvesting Strategy Effectively
Economic downturns can sometimes provide value to investors as well. One way of harnessing the limited benefits offered in such circumstances is through tax-loss harvesting. You can plan the tax-loss harvesting and minimize the tax liability.
Tax laws allow investors to take advantage of matching investment losses against realized gains as long as they comply with regulations.
Here are few key considerations when planning for an effective tax-loss harvesting strategy.
Consider the Tax Brackets for Capital Gains
Short-term gains are taxed like your ordinary income. However, capital gains come with different tax brackets. Currently, these tax brackets are 0%, 15%, and 20%. You must take care of these tax brackets as you’ll need to first offset the capital gains against capital investment losses.
You can then offset short-term investment gains as well, provided you do not exceed the allowed limit of $1,500 single or $3,000 joint filing.
A limitation with tax-loss harvesting is the threshold of $3,000. You cannot exceed the limit in a single tax year filing. However, you can defer the capital losses to offset them against future capital gains.
You’ll need to consider a long-term investment plan if you want to take full advantage of loss harvesting.
Alternative Cash Investment
Although tax-loss harvesting can minimize your tax liability, it isn’t always the best option. You can use the cash received from sold securities for alternative investments as well. Ideally, you should invest in similar securities with better performance indicators to reap rewards in the future.
Portfolio re balancing can be a better option from the sale proceeds of losing securities. Whatever purpose you can think of, ensure to match the gains against potential tax benefits.
Holding your Loss-Making Securities
Another key consideration is to keep your losing stocks for a while. Investors plan for long-term gains and do not make frequent transactions to harvest tax losses quickly.
If it’s inevitable to sell a security, you should go for it and match the losses against realized capital gains. However, it cannot be the best outcome with every loss-making security. You must compare the long-term benefits of value appreciation in the underlying security against tax gains.
If you have planned a tax-loss harvesting strategy, you may need to make several transactions to sell the securities. It means the strategy will incur substantial administrative costs.
As a natural alignment, you can do the period adjustments for such transactions. However, you must weigh the administrative costs against tax benefits carefully.
You can best harness the benefits of a tax-loss harvesting strategy if you have built a diversified investment portfolio. Ideally, if your investment portfolio comprises stocks, mutual funds, and ETF, you can perform well with tax-loss harvesting as well.
If you comply with tax regulations and plan well, you can benefit from the tax-loss harvesting strategy. You can turn the loss-making securities to offset capital gains and reduce the tax liability. It can also be used as a portfolio re balancing tactic.