An Upside of a Down Market? Tax Loss Harvesting to Help Minimize Taxes
During bear markets or times of stock market volatility, it can be tempting to tune out financial news and stop checking your account until things get better. However, bear markets allow you to sell your losing investments while minimizing capital gains taxes. Learn how a tax loss harvesting strategy can help you reset your portfolio and enjoy a tax benefit.
How tax loss harvesting works
After a 10 + year bull market for stocks, many of us may be holding onto stocks we’d like to sell but are reluctant to pay capital gains taxes on. Through tax loss harvesting, you can apply capital losses from the sale of one investment (which could be an individual stock, bond, mutual fund or ETF) and apply it against capital gains from selling another asset. Doing so, you help minimize or eliminate any capital gains taxes from selling the investment that has risen in value.
For example, let’s say you bought 100 shares of Company A in 2018 for $10 each. The stock has soared in value, and now the shares are worth $40 each, giving you a gain of $3000. You’d like to sell to lock in some of your gains but don’t look forward to paying the related tax bill.
In 2019 you also bought 100 shares in Company B for $50 each. Unfortunately, this stock has performed poorly and is now worth $25. You’d like to sell and invest the remaining $2500 in something more promising.
If you sell all your shares of Stock A, you will face capital gains on your profit of $3000. However, if you also sell Company B and utilize tax loss harvesting, you can reduce the amount subject to capital gains taxes from $3000 to $500 ($3000 – 500) by applying the loss against the gain.
If you choose, you can then purchase a similar type of investment as the one you sold to harvest the loss to keep your portfolio balance the same. So if Company B was a technology stock that fell in value, you can sell it at a loss and then invest in another tech company if you still want exposure to that sector.
You can use up to $3,000 a year in losses to offset ordinary income. You can carry the remainder to future years if you have accumulated more than $3,000 in losses in a given year.
Note that tax loss harvesting should only be used in a brokerage account subject to taxes. The strategy isn’t helpful for retirement accounts such as your 401(k) because you can’t deduct losses from a tax-deferred account.
Avoid a potential “wash sale”
In selling and buying investments for tax loss harvesting, you want to avoid a potential “wash sale.” Under this rule, you cannot sell an investment at a loss for the tax benefit, then immediately buy that same security or a “substantially identical” one within 30 calendar days after the sale.
Violating the wash sale rule means that the IRS won’t allow you to use the loss to offset any gains. However, a financial advisor can help you through selling an investment without triggering the wash sale rule, as well as finding similar investment options if you want to stay invested in a particular sector.
Other potential downsides of tax loss harvesting
The decision to harvest tax losses in your portfolio may not be suitable for you. Selling a security at a loss, then buying a similar security for less money will lower the overall tax basis of your portfolio. But, assuming the new holding rebounds in value, you’ll eventually face capital gains on that investment, negating any earlier tax benefit.
Also, attempting to purchase a similar security to the one you are selling could lead you to invest in an inferior investment or one that charges higher fees. And it’s unwise to opt to sell a money-losing asset solely for a tax break. Analyze your holdings based on your financial goals and risk tolerance.
Monitoring your investment gains and losses and deciding to implement tax loss harvesting can be difficult to manage on your own. An experienced financial advisor can help you find opportunities to rebalance your portfolio while minimizing the tax impact and following all the IRS regulations.
The Bottom Line
Nobody likes to see their investments fall in value. However, savvy investors spot opportunities in good times and bad. By tax loss harvesting, you can unload stocks that have fallen in value while lessening the impact of taxes on your better-performing investments.
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