Tax loss harvesting: What it is and how it works
What is tax loss harvesting?
A tax loss is a loss that you can offset with profits in other areas. Tax loss harvesting and tax gain harvesting are tax strategies that you can use to reduce the taxes that you might have to pay.
In tax loss harvesting, you can offset your income or capital gains by your investment losses, and a tax offset can reduce your gains tax. The capital gains tax is a tax on the profits that you make by selling certain types of investments. These might include gains you realize from selling stocks or from selling real estate. You calculate your capital gain by taking the total sale price and subtracting the original purchase price of the security or other types of investments.
When you sell an asset for less than you paid for it, a capital loss occurs. Tax harvesting allows you to use some of these losses as a tax offset against your gains on your tax return.
You are allowed to claim up to $3,000 in losses per year to offset your ordinary income when you have more losses than gains. you can then carry over the remainder to future years.
Tax gain harvesting
Tax gain harvesting occurs when you sell your investments at a time after they have appreciated instead of selling them at a loss. The key to tax gain harvesting is to time it in such a way that it is a beneficial tax strategy.
If the current gains tax rate is lower than you anticipated, selling your investment while the rate is lower may be better than selling it at a later date when you will have to pay more.
Partial planning is a strategy in which you harvest the gains on a portion of your holdings. Normally, this is done on the shares that have the lowest gains. This leaves you with more shares that have a higher basis. What remain is more shares that can be sold for reduced gains if the price rises. They also might be used for tax loss harvesting if the price falls in the future.
Tax gain harvesting is not a good strategy when you have very large gains. It is also not a good idea if you owe state income taxes. Paying state taxes now to harvest a capital gain may cause you to lose out on the future growth of that amount. Finally, gain harvesting should not be used if your gain will move your income or deduction limits.
According to data from the World Bank, approximately 82.6% of taxes in the U.S. come from taxes on capital gains, income, and profits. The Tax Policy Center reports that during the most recent tax year for which data is available, Americans reported taxable net gains totaling more than $634 billion. During the same year, Americans reported more than $20 billion in taxable net losses.
This data suggests that Americans reported far more gains than losses, which means that many people may not have taken advantage of tax-loss harvesting to reduce the gains tax that they had to pay.
How to apply tax loss harvesting
Tax loss harvesting may offer you the ability to reduce your gains taxes if it is done correctly. Start by separating your long-term gains and your short-term gains.
This is important because the short-term capital gains tax rate is different than the long-term capital gains tax rate. The short-term capital gains tax rate is the same rate that you pay for your ordinary income tax rate. The long-term capital gains tax rate is 0%, 15%, or 20% and depends on your income.
After you have categorized your losses and gains into short- and long-term, apply your capital losses to offset your gains. Short-term gains and losses are realized when you sell investments that you have held for 12 months or less. Long-term gains are realized when you sell investments that you have held for 12 months or longer.
List your long-term losses with your long-term gains. Then, list your short-term losses with your short-term gains. You can only use the same type of loss to offset the same type of gain. For example, if you held a security from company A for 9 months and sold it at a loss, it could not be used to offset a gain that you earned from selling a security from company B that you held for 13 months and sold at a profit.
You can only apply a loss of up to $3,000 to reduce your taxable income. If you are married filing separately, you and your spouse are limited to $1,500 each. You can carry any additional tax loss that you have over to use on future tax returns.
An example of tax loss harvesting might make the strategy a little easier to understand. Say that you purchased 10 shares of stock from company A on Jan. 1 at a price of $20 per share. You hold the shares until April 1 of the following year and sell them at price of $40 per share. You will need to start by determining your cost basis for the asset so that you can understand the net asset value.
If you paid a transaction fee of $15 at the time that you purchased the shares, your basis would be calculated as follows:
(10 x $20) + $15 = $215
When you sell your shares, you can calculate your capital gain as follows:
(10 x $40) – $215 = gain of $185
If you also purchased 10 shares of stock from company B that you have held for more than a year that have declined in value, you can sell them to harvest the loss to offset your gain. If you purchased the shares from company B at a price of $20 per share and a $15 transaction fee, and you later sold them at $15 per share, you can calculate your loss as follows:
(10 x $20) + 15 = $215
(10 x $15) = $150
$215 – $150 = loss of $65
Your loss of $65 could then offset your gain of $185 for a net taxable gain of $120.
When you offset the claimed income amount on your tax return, it can help to minimize what you pay in capital gains taxes. A capital gain or loss is not realized until you sell your capital asset.
Capital gains and losses do not apply to tax-deferred accounts such as 401(k)s or IRAs, which means that you cannot use tax loss harvesting for securities that you hold in these accounts. Tax harvesting is commonly done as a year-end strategy for tax purposes, but it may be done at any time of the year.
There are several benefits of tax loss harvesting. Your tax losses may be able to defer the capital gains taxes that you would otherwise owe. After you offset your realized gains, you are able to apply any remaining losses to deduct up to $3,000 from your income taxes each year.
If you have remaining losses, you can roll them over to use in future years so that you can defer your capital gains taxes until your losses are exhausted. Even if you do not currently have any gains, there are benefits to harvesting losses because they can be used to offset your future gains or income.
Wash sale rule
A wash sale occurs when you trade or sell securities at a capital loss and then purchase substantially identical securities within 30 days before or after the sale. A wash sale also occurs when you purchase a contract or option to purchase substantially identical securities within the 60-day window of selling your assets at a loss.
This is an important rule to understand because the IRS does not allow you to purchase an asset and sell it strictly for the purpose of paying lower taxes. According to Schedule D of the 1040 tax form, capital losses are not allowed if you purchase substantially identical assets within 30 days of selling them at a loss. Instead, you should wait for more than 30 days between the time that you sell a security and repurchase it if you want to satisfy the wash sale rule. Under the rule, the entire time period is 61 days, including the date of the sale, 30 days after it, and 30 days prior to it.
A wash sale occurs when an individual sells securities at a loss and the individual or his or her spouse repurchases the securities within the 61-day window. It also occurs when a company controlled by the individual sells securities at a loss and repurchases them within the window.
According to the IRS, the stocks of one company are not considered to be substantially identical to the stocks of a different company. However, the securities could still be considered to be substantially identical such as the stocks of a predecessor company and a successor company in a reorganization.
The preferred stock or bonds of a corporation are normally not considered to be substantially identical to the same corporation’s common stock. However, if the preferred stock or bonds can be converted into the corporation’s common stock, the price changes, relative values, and other circumstances may make them substantially identical to the common stock. Finally, selling options at a loss also falls under the purview of the wash-sale rule.
Who is tax loss harvesting for?
Tax loss harvesting is good for young investors because they can anticipate many years to invest. They have more years in which their losses can be offset. The longer the period of time that you have to invest, the greater the benefit could be to you.
Tax harvesting is also beneficial to investors who are in higher tax brackets. For these people, offsetting gains with losses can help to reduce the taxes that they might have to pay. Finally, it is a good choice for people who might want to offset their taxable incomes in the future.
Cost basis and tax loss harvesting
Your cost basis is the total price that you paid to purchase a security, including purchases that you make through reinvesting dividends or capital gains distributions. it also includes other costs such as commissions and transaction fees.
Your cost basis helps to determine how much taxes you might expect to pay on an investment. It also helps you to determine your gains or losses for the purposes of selling or buying. The cost basis method that you choose can make a difference in your taxes.
The average cost basis method of figuring your cost basis is a fairly straightforward method to use. With this method, you simply divide the dollar amount that you have invested in a security by the number of shares. You then compare it to the sales price to determine losses or gains for tax reporting. For securities that are purchased and sold as a part of the cost basis information, taxpayers must report them to the IRS.
Using the actual cost basis method of calculating your cost basis allows you to pick specific, higher-cost shares to sell to increase the amount of your realized loss. This makes this method potentially more beneficial for tax loss harvesting.
When is tax loss harvesting not advantageous?
Tax loss harvesting is not beneficial in several situations. Since you cannot deduct the losses in your 401(k) or IRA, tax harvesting cannot be applied for these types of accounts.
There are also restrictions on using specific types of losses to offset specific gains. The short-term capital gains tax is different than the long-term capital gains tax. Thus, a long-term loss would first need to be applied to long-term gain. A short-term loss would first need to be applied to a short-term gain. If you have excess losses in one category, you can apply them to gains of either type.
When you sell and buy securities, it can increase your administrative costs. Administrative costs affect the net asset value of your securities. You should only apply tax loss harvesting if the tax benefit outweighs your administrative costs.
This makes it beneficial for you to consider an online investment platform that does not charge commissions, costs, or fees because the benefits of tax harvesting will always outweigh your administrative costs, and the net asset value of your securities will not be impacted.
Minimize the tax burden with M1 Finance
M1 Finance is a powerful online investment platform and mobile investing app that allows you to invest without paying any commissions or transaction fees. This feature allows you to benefit from tax loss harvesting in your taxable investment account.
Robo-advisors automatically complete tax harvesting of your portfolio. Often, robo-advisers will harvest losses daily. M1 has tax efficiency features built-in, which helps you to automatically reduce the amount of taxes that you will owe.
M1 blends key investing principles with powerful digital technology to simplify the investing process, so you can build wealth effortlessly. Its award-winning investment tools accelerate the growth of your money while simultaneously reducing your tax burden. Your investments are automatically rebalanced, allowing your savings to grow in a more efficient manner and with greater tax savings.
Simple, secure, free investing. Opening your account with M1 Finance is simple. You can open an account for free and then create your own custom portfolio. If you prefer, you can simply choose an investment portfolio that has been created by experts from more than 80 that were created to meet different financial goals and levels of risk.
Tax and Legal Advice Disclaimer. M1 Finance and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.