There are many facets to investing. One thing all investors will not want to overlook is the tax consequences that come with being a successful investor.
Because all net profits made from investments sold in taxable brokerage accounts come with tax liability, your investment strategy should consider the consequences.
To reduce tax liability, a strategy called tax-loss harvesting is often employed.
It's used to offset capital gains resulting from a profitable securities sale.
Harvesting of tax-losses can also be used to reduce up to $3,000 ($1,500 if married filing separately) of your regular income or other non-investment taxable earnings if you have more losses than gains.
Further, you can carry additional losses over to future years.
It's for investments producing taxable gains. Stocks and actively managed mutual funds or ETFs within a brokerage account are prime candidates.
Tax Consequences Related to Buying and Selling Securities
First, you need to keep in mind that any gains you make during a calendar year can be offset by any losses you incur during the same calendar, with some restrictions.
Also, there are carry-forward tax provisions that will allow you to carry forward losses from prior years.
Your gains minus your losses on investments you sell, make up the net investment income on which you'll calculate your tax liability.
Next, you look at the tax rate.
Determination of your applicable tax rate on securities transactions is based on the amount of time you held a particular security before selling.
If you hold a security (stock or mutual fund) for one-year or less, the net income from the investment is treated as ordinary income. It is a short-term capital gain, and the applicable tax rate would be your statutory tax rate.
If you generate profits from securities held for one day over a year or more, it's considered a long-term capital gain. The applicable tax rate is then determined by the IRS' capital gains tax chart.
The actual rate you use depends on your income tax bracket and tax filing status. The maximum short-term capital gains tax rate is 20%.
2021 Long-Term Capital Gains Tax Rates & Brackets
|Rate||Unmarried Individuals, for Taxable Income Over||Married Individuals Filing Joint Returns, for Taxable Income Over||Heads of Households, for Taxable Income Over|
The capital gains tax is taken right off the top at the applicable rate. It cannot be lowered with tax deductions. Thus, to lessen your capital gains tax liability, experts recommend the tax-loss harvesting strategy.
How Does the Strategy Work?
The IRS sets the rules for our tax-paying system. Us taxpayers are given the responsibility for paying the least amount of taxes possible following those rules.
Winning for the taxpayer amounts to effectively using the rules to keep their total tax liability as low as possible.
Abide by the rules and timing guidelines and you might have an opportunity to harvest tax losses, thereby lowering your tax liability.
Here's how the process for the tax-loss harvesting strategy process works.
Let's say during the year, you sold the following:
- Security 1 – Cost basis of $10,000, sold for $15,000, held for 400 days
- Security 2 – Cost basis of $20,000, sold for $25,000, held for 380 days
- Security 3 – Cost Basis of $20,000, sold for $30,000, held for 130 days.
You kept the following security in your portfolio:
- Security 4 – Cost basis of $50,000, current value of $40,000, been holding for 500 days
For the year, your long-term capital gains income is $5,000 ($15,000 – $10,000) on Security 1 and $5,000 ($25,000 – $20,000) on Security 2. Your total long-term capital gains income for the year is $10,000 ($5,000 + $5,000).
You'll treat income from Security 3 is as ordinary income as it is a short-term capital gain.
At a 15% Capital gains tax rate, your liability would be $1,500 ($10,000 x 15%).
Security 4 is currently showing a loss of $10,000 ($50,000 – $40,000). If you were to sell Security 4 in the same calendar year as the above gains, you would have a $10,000 credit to offset against the $10,000 capital gains income for a net of ZERO capital gains income for the year.
You just harvested tax losses and saved $1,500 in taxes.
It gets even better.
You can immediately reinvest the proceeds from the sale of Security 4 while effectively losing no portfolio value.
The only stipulation, known as the “wash-sale rule,” is you have to invest that money in a securities strategy not similar to the one you sold. After 30 days, you could then repurchase the same security or something similar.
While many perform their reaping at the end of the year, tax-loss harvesting is something you can do any time of year. Many robo-advisors such as Betterment, Wealthfront, and Wealthsimple will even do this for you.
Benefits of Tax-Loss Harvesting
The real advantage of the tax-loss harvesting strategy should be clear. It provides you the opportunity to offset capital gains income, and lower your tax liability by merely selling a security, perhaps sooner than you had planned.
If the tax savings are significant enough, you have done yourself a good deed.
There's another benefit that might not be as clear. If you're in a particular tax bracket but sitting on the cusp of the next lowest one, you could harvest a tax loss to reduce income and move down to the lower tax bracket.
That could be the difference between sitting in the 15% bracket and moving down to the 0% capital gains tax bracket. And that could generate a whole lot of tax savings.
Remember, you can harvest tax losses on both short-term and long-term positions to create this advantage.
Disadvantages of Tax-Loss Harvesting
No matter what you do in the investment realm, there are disadvantages.
First, harvesting a tax loss for this year takes the possibility of using the loss from that security in a subsequent year. That could be costly if the tax rates were to increase in the following years, giving you more tax savings.
You also run the risk of creating a credit that's much bigger than needed, although this can be carried forward.
There is one more disadvantage worth mentioning.
If the security you sold as part of your tax-loss harvesting suddenly goes up and you were unable to repurchase it before it climbed, you would experience what investors call a loss of opportunity.
Should you choose to implement a tax-loss harvesting strategy, you'll want to select the loss position least likely to recover within the next 30 days.
Remember, after selling a security for a loss and using it in a tax-loss harvesting strategy, you (or your spouse) cannot repurchase that security or purchase a similar security for 30 days.
You also cannot buy a similar security for 30-days before the loss sale.
If you purchase anything with the proceeds from a harvesting transaction, be very careful not to violate the 30-day rule. Such an error could result in tax evasion charges.
There's more. The IRS's denial of the tax-loss harvesting transaction might push you into a higher tax bracket. That could result in higher tax liabilities you weren't expecting.
Is Tax-Loss Harvesting Right For Me?
There's a lot that goes into answering this question properly. It requires you to determine what the risk/reward value of such a strategy would be for you now and in the future.
Like financial rules of thumb, not everyone works for every individual.
For example, if you are in a low tax bracket now and expect to be in a higher one in the future, now may not be the best time to use the tax-loss harvesting strategy.
There are two things you can do to help you decide whether or not this strategy is good for you.
First, you could run some numbers for this year and next and do a little tax planning. That could shed some light on whether it’s worthwhile to pull the trigger now.
Your other option is to consult with your investment adviser. They can likely provide you with a better idea of how such a strategy would play out taking into account your circumstances.
Carefully consider your overall long-term investing plan before selling down investments from your portfolio.
Whether the tax-loss harvesting strategy will work for you or not is not something you should leave to chance.
Vicki and Amy are authors of Estate Planning 101 – a Crash Course in Planning for the Unexpected -coming soon from Adams Media.