When the market it down — like it is now — it’s a good time to be thinking about tax loss harvesting. What is tax loss harvesting? And is tax loss harvesting even worth it? Here are 9 things to know.
- Tax Loss Harvesting is a Great Technique to Save on Taxes
Tax loss harvesting may sound like something you only need if you’re uber wealthy or a day-trader. But anyone with a non-retirement investment account can benefit. During down times of the market, or if you have any individual stock or fund that you’ve lost money on (regardless of the market) you can benefit from tax loss harvesting. It’s much simpler than it sounds. As I’ll detail further, it’s a great way to save on taxes.
- Tax Loss Harvesting Only Makes Sense for Non-Retirement Investments
Because of the way the rules work, tax loss harvesting isn’t beneficial for non-retirement accounts, instead, it should be used for any non-retirement stocks, funds, ETFs, bonds, and the like.
- Tax Loss Harvesting Can Allow Any Gains You Have This Year to Be Tax Free
Usually, when you sell a stock, you pay tax on the earnings. If it’s a long-term investment (greater than a year) you pay capital gains tax at a rate reduced from your ordinary income tax. Short term gains (investments held less than a year) are taxed at your ordinary income tax rate. But, tax loss harvesting allows you to offset – that is reduce – your gains by the losses you had.
Here’s an example we will use for the rest of this post. Say you bought $50,000 of a diversified index fund. The market is way down this year and now this investment is only worth $30,000. You have lost $20,000.
Let’s pretend you also work for a startup company – Company Z – and you have $50,000 of Company Z stock. Company Z is doing amazing and now your stock is worth $65,000.
But, you don’t love your job and decide to leave it for a new company. You want to sell all of your Company Z stock. If you sell your stock you will be taxed on $15,000. BUT, if you also sell your Index Fund, you will have a loss of $20,000 that will offset this $15,000 gain. So, you won’t be taxed on your Company Z gains at all!
(If you’re worried about selling your Index Fund, keep following along.)
- Tax Loss Harvesting Can Also Reduce Your Taxable Ordinary Income By Up to $3,000
The great thing about Tax Loss Harvesting is it can also reduce your taxable ordinary income by $3,000. So, carrying on with the example above – if your taxable income was $100,000, you can keep using up your losses (remember you still had $5,000 of losses left), and now your income will only be taxed at $97,000.
- Your Losses Carry Over Indefinitely
In this example, you are probably wondering what happens to the $2,000 of losses that you still had left. Should you sell another stock that’s appreciated just to use this loss? Not unless you need the money! Instead, you can carry forward the $2,000 loss to use the next year – to offset gains or reduce your ordinary income.
- Tax Loss Harvesting is Especially Beneficial If You Are a High Earner
My favorite way to use tax loss harvesting is if I know that I won’t be selling any appreciated assets this year, will have a really high tax bill, and know that next year my income will be less and I will be selling some assets. Here’s why: If my current tax rate is at 25%, a $3000 reduction in income will save me $750 in income taxes alone.
- You Use Short Term Losses to Offset Short Term Gains (and Long Term Losses to Offset Long Term Gains)
It’s important to know that tax loss harvesting is especially beneficial for short term gains. Since short term gains are taxed at your ordinary income tax rate, if you can use a short term loss to offset that gain, it will really save you a lot of money.
- You Can Immediately Invest in Similar Stocks and Funds
The great thing about Tax Loss Harvesting is you don’t have to sell your stock and sit out for good – you can immediately reinvest in a similar stock or fund. It just can’t be “substantially identical.” With the diversity of funds these days, it’s pretty easy to just swap out one fund for a similar one. Many investment platforms even tell you in the fund’s research section what other funds are similar. So if you are looking for a diversified global fund, you can probably sell the one you own and immediately buy another that looks a lot like it.
- But Watch Out for Wash Sales If You Reinvest in the 30 Day Window
If you are immediately reinvesting, watch out for the “wash sale” rule. This rule says that your loss is disallowed if you repurchase the same stock or fund within the same 30 day period. Continuing with the example above, say you sold your Company Z stock for $65,000 ($6.50 a share). A few days after you sell the stock drops by a lot – now it’s only $5 – but you believe it will go back up – so you purchase the stock again at $5/share for $50,000. Unfortunately, your $15,000 will not be allowed by the IRS. This is especially important to watch out for if you participate in an employee stock purchase program or have recurring investments set up.
Tax loss harvesting may sound like a lot of work; but in a down market or when you have a disappointing stock, it can save you thousands of dollars in taxes. In my opinion, if you are an in a high-earner tax bracket and have losses that you can swap for similarly situated funds, it is worth it to engage in a tax-loss harvesting strategy.
Have you used this strategy? How did it work out for you?