The Essentials of Tax Loss Harvesting (TLH)
Investors are often told they should be taking advantage of Tax Loss Harvesting, especially when markets are down. This is because the tax benefits of TLH can be huge! However, when used at all, TLH is typically done at the end of the year. If you’re in the majority that doesn’t fully understand TLH, how it works, what the benefits are, or how to implement it, this blog is for you!
What is Tax Loss Harvesting?
TLH is selling an investment while the price is down, in order to intentionally realize a capital loss as a tax strategy. By replacing the investment that was sold with a similar one, your investment strategy stays intact and you are able to fully capture the investment’s recovery.
What’s the catch?
There are a couple of things investors should be aware of when executing this strategy:
Avoiding the Wash Sale Rule is paramount in making sure TLH is a successful strategy. The Wash Sale Rule is an IRS rule that disallows any tax benefit if you sell an investment at a loss, and then buy the same or a “substantially identical” investment back within a 61 day (30 days before or after) window of the sale. The key here is replacing the investment you sold with an appropriate one. For more on the Wash Sale Rule, check out this article.
Even those who may know what TLH is and how to avoid the Wash Sale Rule still struggle to implement it effectively. The main obstacle in applying TLH is the discipline to closely track your investment portfolio, identify the holdings that are at a loss, and then sell them at the right time. Investors need a process in place to be alerted to those key moments or else they will miss them.
What are the benefits?
The benefits of TLH are tax deferral, and oftentimes, tax reduction. Additionally, alongside other tax strategies like charitable giving, TLH can play a key role in avoiding tax altogether. Let’s break these main benefits down:
Offset gains. Taxpayers have the ability to use capital losses to offset capital gains. For example, if you sold stock at a gain in January and then sold another stock at a loss in December, the loss from December is used to offset the January gain. In this scenario, the taxpayer avoids paying up to 20% of capital gains tax. Additionally, capital losses from your investment portfolio can also be used to offset capital gains from other assets like the sale of a home.
Reduce taxable income. If a taxpayer’s capital losses exceed their capital gains, up to $3,000 of losses per year are used to reduce ordinary taxable income. For those in higher tax brackets, that means up to $1,500 of tax savings per year.
Carryover. What if you don’t have gains to offset now, but it’s a good time to realize losses? Great news: you can carry over realized capital losses to future years! That way, the capital losses you realize now can still be used to offset future capital gains.
It’s important to note that these 3 benefits of TLH are tax deferral and reduction strategies. With the help of a tax professional, you can maximize TLH even further. By strategically taking capital gains in low income years, capital gains tax may be avoided altogether. Similarly, by building a bank of carry over losses, years with the potential of large capital gains tax can be mitigated significantly. Finally, with the use of charitable giving strategies, like donating appreciated securities and utilizing Donor Advised Funds (DAF), capital gains tax can be avoided altogether.
How do you implement it?
At Redeem Wealth, we encourage simplicity in your finances whenever possible. This is why we combine financial planning and professional tax services, so that our clients can keep more of their wealth. This is also one of the primary reasons we use Betterment for holding client accounts. With Betterment, many features like TLH are automatic¹ - our clients don’t have to think twice about it. If you have further questions about TLH or want to talk more about your specific financial situation, feel free to schedule a time with us!
