Tax Loss Harvesting is a Great Way To Save On Taxes
What exactly is Tax Loss Harvesting?
The Tax Loss Harvesting is a method in which you use losses in investments to save on taxes that you pay for your investments’ capital gains. The strategy is to show the IRS that while you made some money on some investments, you also lost money in other investments. This way you would pay lower taxes on your investment accounts.
What you basically do is you sell your investment at a loss (the ones that weren’t doing that well anyway) and then buy other, similar investments. This way, you get to keep your asset portfolio allocation while also saving on taxes.
Tax rules regarding capital gains and losses
So why should you sell your investment to be able to get a tax cut? It is simple. You cannot report an unrealized loss. You need to realize your capital loss (read – sell at a loss) to be able to report it to get a tax cut on that loss.
Capital gains, or the profit you make on the sale of an asset or investment, must be reported as income when you are filing your taxes. And these profits are taxed.
Capital losses, the loss you make on the sale of an asset or investment that was actually supposed to increase in value, must be reported as deductions in your tax returns.
Here is an example to make things clearer:
You buy stocks worth $50 in January 2017. However, by August, the stock prices drop to $30. You have an unrealized loss of $20 here. But you don’t sell. You hold on to the stocks, hoping to see a gain in the stock price. By January of 2018, the stock prices climb to $45 and you decide to sell. Now, you realized loss is $5. Which is what you report in your tax returns. So you get a tax deduction for the $5 you lost.
So, once you have sold your securities and realized your losses, you can deduct those losses from your capital gains. If you still have losses even after those deductions, then you use them to balance out the taxes you would have to pay for your wages or other sources of income up to $3,000. If you still have losses after balancing out all your income for the year, then you can carry those losses forward to the next year and use them to balance your future tax returns.
Here is an example of how it works:
You have 4 investments. 2 are long-term investments, which means you have owned those investments for more than 365 days and 2 are short-term investments which are less than a year old.
You are, say in the 25% tax bracket. This means that your long-term capital gains will be taxed at a 15% rate.
Now, here is the list of your investments:
A – $75,000 (realized gain, asset owned for 375 days)
B – $50,000 (unrealized loss, asset owned for 400 days)
C – $60,000 (realized gain, asset owned for 250 days)
D – $25,000 (unrealized loss, asset owned for 100 days)
Here is calculation:
((Long-term capital gain – long-term capital loss)X15%) +
((Short-term capital gain – short-term capital loss)X25%) = capital gains tax
((75,000 – 50,000) X 15%) + ((60,000 – 25,000) X 25%) = $12,500
If you did not deduct your unrealized losses, then this is how much you would pay:
(Long-term capital gain X 15%) + (Short-term capital gain X 25%) = capital gains tax
(75,000 X 15%) + (60,000 X 25%) = $26,250
Savings: $26,250 – $12,500 = $13,750
That’s about 50% of your tax deductions saved!
You can make your life easier by using a capital gains calculator to help you understand how much you would save on taxes through tax loss harvesting.
The Wash Sale Rule
Keep in mind that the IRS enforces the wash sale rule. This means that you cannot sell a stock at a loss and buy an almost identical stock or security in its place within a 30 day period before the sale of after it.