Who doesn’t like free money? “Tax loss harvesting” is an investment tactic that does just that – gives you free money. And December is just the time to do it. Careful use of tax loss harvesting can take off up to $3,000 from your taxable income this year, just in time for the Christmas holidays.
What is tax loss harvesting?
In brief, tax loss harvesting allows you to off-set capital gains or regular income with capital losses from investments. Here is how it works. When you have an investment such as a stock or mutual fund that increases in value, the difference between the price that you paid to buy it and the price when you sold it is capital gains. If that difference is a positive value, you pay taxes on those capital gains based on your capital gains tax rate which in turn depends on your income level. There are two types of capital gains: short-term and long-term. Short-term capital gains are those on investments that you have held for less than 1 year and are taxed at your regular income tax rate. Long-term capital gains are on investments you have held for more than 1 year and are taxed at your capital gains tax rate. Most people fall into the 15% capital gains tax rate bracket.
IMPORTANT: capital gains taxes only apply to regular investments and not retirement accounts such as a 401(k), 403(b), 457, or IRA. You will pay regular income tax on all withdrawals from retirement accounts.
One the other hand, if that investment lost value from the time you bought it to the time you sold it, you have a capital loss and this is where tax loss harvesting comes into play. There are two types of tax loss harvesting:
- Use a capital loss to offset a capital gain. You get taxed on your net capital gains when you add up all of the investments you sold that you made money on and lost money on. So, if you made $5,000 in long=term capital gains from the sale of one investment but had $5,000 in long-term capital losses from the sale of another investment, the gains and the losses balance out so you do not owe any money in capital gains taxes that year. You have to track and report short-term and long-term capital gains/losses individually and the IRS requires you to first apply short-term losses against short-term gains and apply long-term losses against long-term gains before you can apply short-term losses against long-term gains and vice versa so the IRS reporting on your tax forms can get a bit complicated.
- Use a capital loss to offset regular income. What happens if you either do not sell any investments for a capital gain this year or if you sold more investments for a loss than you sold for a gain? You can apply net capital losses up to $3,000 against your regular income. In other words, you can reduce your taxable regular income by $3,000. If your effective income tax rate is 18.00%, that means that you can avoid paying $540 in income tax on that $3,000. In addition, that reduction of $3,000 from your taxable income will drop your effective income tax rate to 17.93% which in turn will drop your income tax by an additional $180 for a total reduction of $720 in income tax. The net effect: you get $720 in free money!
What are the rules?
First, you have to be able to calculate your cost basis (what you actually paid when you originally purchased an investment). To do that, you have to know the date that you bought an investment and the date that you sold an investment. You also need to know the amount of money that you originally paid for that investment when you bought it and the amount of money you sold it for. This can get a little tricky if you purchased shares of a stock (or mutual fund) on different dates. It can also get tricky if you are automatically re-investing dividends from a stock (or mutual fund) to purchase additional shares of that stock (or mutual fund). Fortunately, most of the large investment companies will track your mutual fund investments for you and will be able to tell you what your short-term and long-term capital gains are at any given time with just a click of your mouse. This allows you to calculate how many shares of a mutual fund you need to sell in order to have a $3,000 capital loss.
Second, you have to avoid a wash sale. The IRS does not allow you to sell an investment to take a loss and then turn around and immediately buy back that investment right away – this is called a wash sale. To avoid wash sale penalties, you have to wait at least 30 days before you purchase shares of the stock (or mutual fund) that you just sold. You can, however, sell a losing stock (or mutual fund) and use the proceeds to buy a different, dissimilar stock (or mutual fund).
Third, you have to fill out IRS form 8949 when you fill out your annual income tax forms. This form summarizes all of the investments that you sold during that tax year. The total amount from form 8949 then has to be reported on schedule D of your 1040 form. Schedule D is where you can deduct up to $3,000 from your taxable income.
What should I sell?
We are living in the longest bull market in U.S. history. Except for the 6 months between February and August 2020 (onset of COVID), the overall stock market has been steadily going up for the past 11 years. As a consequence, most broad market mutual funds and most individual stock have increased in value rather than decreased in value so you may not have any investments to qualify for tax loss harvesting. However, certain specific types of investments have lost money over the past few years. For example, many U.S. and foreign bond mutual funds have lost value over the year and energy sector mutual funds have lost value over the past 10 years. Check all of the specific stocks and mutual funds in your investment portfolio – those that have lost value since you purchased them are eligible for tax loss harvesting.
It is important that you keep sight of your overall investment strategy which should involve maintaining a diversified portfolio of individual investments. Beware of selling off too much of any one type of investment if it puts your overall portfolio out of balance. For example, don’t sell all of your bond funds in order to harvest a tax loss or you will end up with a portfolio comprised exclusively of stocks and thus making you vulnerable to your portfolio losing too much money if/when the stock market falls in the future. If you sell shares of an energy sector stock mutual fund for tax loss harvesting purposes and you feel compelled to have energy stocks for long term investment purposes, just remember that you have to wait more than 30 days before you can buy new shares of that energy fund.
My investment philosophy has always been to “buy and hold”since investment should be for the long term. Stocks and bonds will go up and down in value and the wise investor will ride out the downs in order to take advantage of the inevitable ups. Tax loss harvesting is one exception to this strategy that can reduce your taxes and put more money in your pocket.
December 3, 2021