If you’re excited about the dividend yields and gains your winning stocks made, yet want to reduce taxes you’ll owe on your taxable investment accounts, you might want to consider tax-loss harvesting. Before trying this financial strategy, it’s important to understand exactly how it works — especially the limitations — or come time to file taxes, you could end up paying more than you expected.
So that you can better strategize for tax-efficient investing, read on for a brief overview of tax-loss harvesting.
How Does Tax-Loss Harvesting Work?
Investors or their advisors use tax-loss harvesting strategies in their taxable investment accounts. They use these strategies to try to lower their tax bills by selling securities — stocks, equity-based mutual funds or exchange-traded funds — at a tax-deductible loss in an attempt to offset the capital gains tax owed on future stock gains.
Basically, if you sell a stock in a taxable account that went up in value after you bought it, you pay what’s known as capital gains tax on the increase in value. But perhaps you’ve sold off other investments in a taxable account at a lower cost than you bought it for. “Harvesting” these sales could set you up for what’s known as tax-loss selling, in which investors use a capital loss to offset their capital gains.
Tax-Loss Harvesting Example
So, what is tax-loss harvesting? Here’s a simple tax-loss harvesting example: You sold an investment in a taxable account for $10,000 more than you bought it for, but you also sold another investment for $10,000 less than you bought it for — so you lost money. Your $10,000 loss offsets the $10,000 taxable gain, so you won’t have to pay the capital gains tax typically owed when you sell an investment for more than you purchased it for.
Tax-Loss Harvesting Limitations
Before you jump into tax-loss harvesting with an eye to offsetting capital gains, it’s critical to clearly understand tax-loss harvesting rules.
- Tax-loss harvesting is limited to investments held in taxable accounts only. So if you want to sell investments with a sub-par performance in your tax-sheltered accounts like your 401k, 403(b)s, IRAs or 529s, you won’t get a tax break with these strategies.
- The timing of the sale of your losing investment is critical. If you want to try tax-loss harvesting this year, it’s better to start sooner than later because all harvesting must be complete by Dec. 31 of this calendar year.
- Another limitation to clearly understand is what are known as IRS “wash-sales” rules. In a nutshell, these rules state that your tax-loss claim won’t be valid if, within 30 days before or after selling the losing investment, you or your spouse invest in an identical or strongly similar investment to the one you just sold.
- The actual amount you’ll save by using tax-loss harvesting depends on how long you’ve held the investment. Investments held for a year or more are considered long-term investments. Long-term capital gains tax rates are lower than short-term capital gains rates, which apply to investments held less than a year.
- Tax losses are capped annually, meaning you can only apply an amount up to the cap against your capital gains for that year — $3,000, as of November 2016, unless you’re married and filing income tax returns separately; then it’s $1,500. Yet there’s some good news for your federal tax return: You can carry forward your tax loss, offsetting future capital gains next year or beyond.
Tax-loss harvesting might not be suitable for everyone, but it does provide tax-saving options for investors with money in taxable investments. So read up on the current tax-loss harvesting rules and regulations to ensure your trades meet the requirements to take advantage of harvesting your investment losses to reduce taxes.
This article was originally published on GOBankingRates.com.
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