By Brandon Miller, CFP–
Uncle Sam and Santa both have white beards, but no one really confuses the two. So, it may surprise you that the skinnier guy delivers gifts this time of year, too.
One of these presents is known as tax-loss harvesting, also called tax-loss selling. Both sound like something awful, but it’s actually a brilliant way to benefit from investment losses. And while you can implement it at any time, many people use the strategy at the end of the calendar year.
Basically, tax-loss harvesting is when you sell investments that have lost value to offset the gains you’re making on other investments. This lowers your tax bill, essentially putting more money in your pocket. Plus, any amount of loss you don’t write off one year can be carried forward indefinitely until it is finally exhausted.
Investment losses can help you in two ways. One is to offset the money you are making with your winning investments. The second way is if you have more losses than gains, including no gains at all. Then you use any excess amount of loss to offset up to $3,000 of your income each year (on a single or joint tax return).
Remember, you don’t generally pay taxes on your investments until you sell them (except for dividends and interest). Investments you sell for more than you paid are capital gains, and those that have lost value when you sell are capital losses. The gains you owe taxes on. The losses, well, we’re getting to that.
The amount of tax you owe on your gains is based on how long you have had the investment. More than one year is considered long-term, while less than 12 months is short-term. Short-term gains are taxed at your ordinary tax rate while long-term gains are taxed at much lower rates—0%, 15%, or 20% depending on your income.
The IRS mandates that your capital losses have to offset the same type of capital gains first. For example, short-term losses have to first offset short-term gains. Any excess can then be used for long-term capital gains and income.
Let me give you an example. Say you sell a long-term investment at a loss of $20,000. You also sell another long-term investment for $7,000 more than you paid for it, as well as a short-term investment that added up to a gain of $3,000. So, the $20k tax loss that you are harvesting is first applied to your $7k long-term gain. Since you have excess, you can also offset your $3k short-term gain. That leaves you with another $10k to harvest. You can now make $3k of your income for the year disappear tax wise, and carry over the remaining $7k in future years.
Pretty cool, eh?
Of course, this is the IRS, so there are some restrictions. This only applies to taxable investments, not tax-deferred investments such as an IRA or 401(k). And there’s a wash sale rule that says that you can’t harvest a loss if you buy the same stock or security—or one deemed “substantially identical”—within 30 days before or after the sale.
Also, tax avoidance shouldn’t control your investment strategy. Rather than sell something that is working well in your portfolio or you believe has growth potential, look for other assets that don’t fit your strategy or that you have lost faith in. Investments that are easily replaced—I’m looking at you, mutual funds—are also good choices.
Tax-loss harvesting also comes in handy for rebalancing your portfolio. Say you exercised some company stock options and now your asset allocation is off because too much of your money is in one investment. You could sell some at a profit and sell off an investment that has lost money. Maybe your Ford stock is down currently, but you still believe in the auto industry. Sell it at a loss and buy some GM stock. You rebalance your portfolio and get a tax break at the same time.
Using losses to offset gains and cut your tax bill through tax-loss harvesting can help you get to your goals faster. Maybe it’s not enough to make you want to run out and get Uncle Sam ornaments for your Christmas tree, but it’s still a pretty great gift for investors.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. Brio does not provide tax or legal advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital; please seek advice from a licensed professional.
Brio Financial Group is a registered investment adviser. SEC Registration does not constitute an endorsement of Brio by the SEC nor does it indicate that Brio has attained a particular level of skill or ability. Advisory services are only offered to clients or prospective clients where Brio Financial Group and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Brio Financial Group unless a client service agreement is in place.
Brandon Miller, CFP®, is a financial consultant at Brio Financial Group in San Francisco, specializing in helping LGBT individuals and families plan and achieve their financial goals.
Published on December 3, 2020
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