Tax Loss Harvesting

If you have investment losses this year, consider “harvesting” those losing positions before year-end to reap tax benefits. Here’s how the strategy of tax loss harvesting works: When you sell a position for a loss, you can use the loss to offset your annual capital gains. If you have additional losses after subtracting the current year’s gains, your losses can then offset up to $3,000 of the current year’s ordinary income. Beyond that, any leftover losses over the $3,000 can be carried forward and used to offset capital gains or up to $3,000 of income in the next year. Carryover losses afford you flexibility to take capital gains in future tax years. Also note that even if you do not have any capital gains this year, you can harvest losses and use them to offset up to $3,000 in ordinary income.

The catch is that the Internal Revenue Service’s Wash-Sale Rule prohibits taxpayers from claiming a loss on the sale of an investment if the “same or a substantially identical investment” is purchased within 30 days before or after the sale date. So, if you harvest a loss on a particular Tax Loss Harvesting.Blog.2015.12.14stock you cannot re-purchase it for 30 days. However, using a “tax swap” enables you to harvest losses and keep your market exposure without running afoul of the Wash Sale Rule. Here’s how: After you harvest a loss, rather than sit with the sale proceeds in cash and wait 30 days to buy the security you sold back, you can invest in a tax swap, a similar but not substantially identical security, to keep your portfolio exposed to the asset class. The broad range of mutual funds and Exchange Traded Funds (ETFs), makes it easy to find an effective replacement for the losing position you sell. For instance, you might sell a losing energy stock and buy an energy sector fund. The swap functions as a 30-day placeholder. After the 30 days mandated by the Wash sale Rule, you either can switch back to your original holding or choose to stay invested in the replacement investment.

Tax loss harvesting can be even more valuable when we take the extra step of considering what your capital gains rate is today versus what it could be in the future. You might have a 23.8% capital gains rate now and expect it to decrease to 15% when you retire. If you offset gains this year, you avoid paying the 23.8% tax. You’d then re-invest the sale proceeds, including your tax savings, and pay a lower capital gains tax by the time you sold the appreciated security. That said, harvesting can be especially timely if you plan to retire in the next few years or, on the other end of the spectrum, if you and your spouse both work now, but plan to have someone stop working once you have children.

For other tax strategies, you may want to read “Year-end Tax Management Strategies” or our recent blog “Surprise Capital Gains Payouts Can Be Painful.” 

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