It’s that special time of year again: Time to do your taxes. Everyone’s got a different approach when it comes to minimizing their payments and maximizing their returns, but there’s always something you can do to improve your bottom line.
Maybe that something for you is tax-loss harvesting. It’s never fun watching one of your investments go in the tank, but selling at a loss might be smart – if you also have some capital gains you need to pay taxes for.
This is one of the easier tactics you can use to lower your tax burden, so let’s head out into the field and see what this harvest can bring us.
What Is Tax-Loss Harvesting?
When you sell a security (a financial investment, like stocks or bonds) and make a profit, you have to pay taxes on your capital gains. But what if you sell a different security for a loss? Assuming it happened in the same tax year, that sale lowers your overall capital gains, which means you pay less tax.
That’s the basic gist of tax-loss harvesting. However, you have to plan ahead; if you’re a U.S. taxpayer, you have to bring your harvest in by December 31 to apply those losses.
Tax-loss harvesting also has to make sense financially for your particular situation. You might be able to lower this year’s tax bill using this tactic, but what about next year’s? Every time you sell a security, you’re changing your portfolio, and that change will have long-term consequences as well as short-term.
When Should I Use Tax-Loss Harvesting?
Most investors will have their money tied up in 401(k)s and other sheltered investments where your capital gains aren’t taxed at the front end. If you’re one of these investors, tax-loss harvesting is obviously not for you.
It’s probably not going to help either if you only have a small bill to pay. If you’re in a lower tax bracket, and you have a relatively modest portfolio of investments, it might be better to just pay the tax now – don’t forget, you have to deal with transaction fees every time you sell a security.
On the other hand, if you’re in a higher tax bracket, or you think you’re going to be moving up the ladder pretty soon, reducing your capital gains now can make a lot of sense. But you still have to make sure you do it the smart way.
What Is The Wash-Sale Rule?
Let’s say you sell one of your securities at a loss. Now you’ve changed the risk/reward balance of your portfolio; if you’re a sharp investor, you’ll fill in that hole you’ve created by buying a similar security, thus restoring your balance.
The wash-sale rule ensures that you don’t purchase exactly the same security you just sold – at least not within the first 30 days. If you abuse this rule, your attempt at tax-loss harvesting will get smacked down by the IRS, and you might have to pay a penalty on top of that.
It’s easy enough to avoid wash sales, though. For example, cryptocurrency is exempt from this rule; you can sell your coin at a loss to deduct from your capital gains, then buy it right back. But it has to be actual crypto, and not an ETF or other crypto-based security.
Speaking of ETFs, these are a great way to harvest if you happen to be invested in index funds. If you’ve got, say, an ETF that tracks the Nasdaq-100 index, you can sell that and immediately buy a different Nasdaq ETF without breaking the wash-sale rule.
The tricky thing here is that index funds tend to go up, not down. You might have to look elsewhere in your portfolio if you want to do some tax-loss harvesting; just make sure you don’t buy exactly the same (or a “substantially similar”) security when you do.
Long-Term vs. Short-Term Tax Rates
Before we go, keep in mind that you’ll be taxed differently on your capital gains depending on how long you held onto your investment before selling. If it was longer than one year, that’s considered long-term, and you’ll pay less – maybe even 0%.
Aside from the transaction fees, there are other reasons not to sell in the short term. The biggest reason is that most smart investing is meant to be long-term, and not speculative. But as you can see, it does make sense sometimes to sell right now for a loss. Re-invest those sale proceeds wisely, and stay tuned to Digital Wager Wire for more helpful investment tips and tricks.
