The tax-loss harvesting strategy has been quite popular in the recent years due to its many benefits for investors who can minimize their capital gains taxes on investments with the help of this strategy.
That being said, some experts have doubted the advantages of tax-loss harvesting and the extent of its positive effects for investors. Hence, here’s how tax-loss harvesting can help maximize returns and how you can use it for your own investments.
What Is Tax-Loss Harvesting?
To put it simply, tax-loss harvesting is the process of selling securities at a loss to offset taxes on both capital gains and income. These very losses can then be written off on your tax return which will then result in you having a net benefit despite selling your securities at a loss.
It’s important to remember that tax-loss harvesting only works for taxable brokerage accounts and should be applied as a long-term rather than a short-term strategy. Some retirement accounts (such as IRA) simply don’t require you to use tax-loss harvesting because they already grow tax-free.
Tax-loss harvesting for tax liability reduction can be done in two ways. One way involves the reduction of tax on ordinary income (by up to $3000) while another way involves offsetting capital gains on investment returns. One more thing to remember about tax-loss harvesting is that you can carry capital gains into the future tax years which is one of the reasons why this is considered a long-term strategy.
Short-Term and Long-Term Capital Gains
One of the most important things to remember about tax-loss harvesting is that there is a variety of different tax brackets that are applied to short-term vs long-term capital gains. While short-term capital gains need to be realized when you are selling investments after less than a year, long-term capital gains are different and need to be realized when you are selling investments after more than a year. In addition to that, short-term capital gains fall into the regular income tax category while long-term capital gains have completely different brackets.
For instance, for the year 2021 long-term capital gains tax rates are divided into three categories: 0% tax rate, 15% tax rate, and 20% tax rate. At 0% tax rate, those filing single have a tax bracket of up to $40,400 while those married and filing jointly have a bracket of up to $80,800. For 15% tax rate, those numbers are $40,401-$445,850 and $80,801-$501,600 respectively. For 20% tax rate, those numbers are over $445,850 and over $501,600 respectively.
Such variety in tax rates for short-term and long-term capital gains means that you will have not one but many possible tax-loss harvesting strategies to use. Short-term capital losses first affect short-term gains – then long-term gains. On the contrary, long-term losses affect long-term, then short-term gains. You can, however, combine the two, but there will still be some nuances to consider in the process.
Along with the benefits of tax-loss harvesting listed above, this strategy also has some additional benefits. For instance, one of the biggest advantages of tax-loss harvesting is the way it can affect your long-term returns. As mentioned earlier, tax-loss harvesting is not a strategy for short-term results but rather for long-term ones which is why, when using it, you need to focus on what you can get in the long run. It’s not the best idea to stick to instant success with this strategy because that’s not what it is about – and it shouldn’t be.
You need to be realistic about the aims you set for yourself when using tax-loss harvesting. You can’t just expect to have less income in retirement by using this strategy. You can use tax-loss harvesting for deferring some of your taxes if you already have a high tax bracket now. Once you retire, your income may be lower which will, in turn, lower your tax brackets. This means that if you draw down less than you make today, you’ll also be paying less in taxes even though withdrawals are still taxed as income.
Things to Consider When Using Tax-Loss Harvesting
Now that you know about the benefits of tax-loss harvesting, you also need to know about some things to consider when you are using this strategy. Many of these will help you perform the process accurately by preparing to it beforehand:
- Mind the Deadline: Firstly, you need to mind the deadline for tax-loss harvesting. One of the biggest things you will notice when using tax-loss harvesting is exactly that because the deadline for this process doesn’t line up the deadline for your individual tax return. Tax-loss harvesting need to be completed by the end of the calendar year i.e. by December 31st. Alternatively, you can apply tax-loss harvesting year-round if you want to really go full into it.
- Remember the Fees: Secondly, you need to remember the fees and be mindful about them. While there is a variety of trading platforms that are completely commission-free, there are still very many traditional stockbrokers that will charge you a fee every time you trade. This means that you need to be especially attentive when trading and see if there are any additional administrative fees or trading commissions before you actually trade.
- Know the Wash-Sale Rule: Thirdly, you need to know what the wash-sale rule is. To put it simply, this rule prevents investors from buying “substantially identical” security, contract, or option within a period of 30 days before or after selling your security at a loss. Interestingly, IRS doesn’t let you sell a security at a loss and then buy it instantly to harvest losses while many other investors do use tax-loss harvesting to reduce their tax bill. Consequently, you will need to wait 30 days to buy the security you sold at a loss. You can, however, buy an investment that is different from the one you sold. After the period of 30 days ends, you will be able to either keep the “replacement” investment in your portfolio or sell it.
To sum up, tax-loss harvesting can definitely help you maximize returns on your investments, but you should definitely make sure that you are doing everything right when using it. Apply the tips from this article to your own usage of tax-loss harvesting.
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