Using tax-loss harvesting to improve your returns.
As tax time nears, it’s useful to brush up on strategies to keep payments to Uncle Sam at a minimum. Tax-loss harvesting is a legal strategy for investors to minimize taxes and increase long-term returns, and it’s often used when investments are worth less than the purchase price. Taxable capital gains can be offset with the loss. But tax-loss harvesting isn’t as simple as it appears. A security or a similar asset that an investor sold can’t be repurchased within 30 days without a penalty under the IRS wash-sale rule. Here are a few benefits and disadvantages of this investment and tax-planning strategy.
Capital gains may be offset.
Tax-loss harvesting rules follow a hierarchy. First, a long-term loss capital is applied to offset a long-term capital gain. A long-term investment is owned for greater than one year. Next, a short-term loss is applied to offset a short-term capital gain. A short-term investment is owned for one year or less. If there is an excess loss in one category, then it can be applied to either a long- or short-term gain. Each year, $3,000 of losses can be applied to ordinary income with the remainder rolled over to use in subsequent years.
Tax-loss selling may generate additional a return.
“Tax-loss harvesting allows the investor to more efficiently produce after tax results that over time can create additional alpha and more effectively meet their goals,” says Andrew Whalen, CEO of Whalen Financial in Las Vegas. Alpha is created when an investment outperforms its related benchmark index. His firm implements prudent tax-loss selling throughout the year. At the end of 2018, when the stock market dropped, many investors attempted to sell stocks or funds with losses to offset profitable sales from earlier in the year, says Daniel Kern, chief investment officer at TFC Financial Management in Boston. Kern sold losing international funds last December, replacing these assets with similar, although nonidentical, global funds.
The wash-sale rule doesn’t allow tax deductions on certain sells.
This IRS regulation penalizes investors who sell a security and then rebuy the same or a substantially identical security within 30 days after the sale. This rule is designed to stop investors from creating losses solely for the tax benefits. The wash sale allows buying a similar, but not identical asset, within the 30-day period after the security was sold and the loss was realized. An investor might sell Apple (ticker: AAPL) stock for a loss on Nov. 1. If the investor buys Microsoft Corp. (MSFT) shares the next day, it wouldn’t be penalized by the wash sale rule; the stocks aren’t substantially identical, but merely from the same sector.
Tax-loss harvesting strategies might reduce a tax bill.
Investors don’t need capital gains to benefit from the tax-loss harvesting strategy. Three thousand dollars of losses can offset tax on ordinary income. If an investor sells a stock for a $3,000 loss, the loss can be used to reduce taxable income by $3,000. So someone in the 24 percent tax rate bracket potentially saves $720 in taxes. For instance, an investor unhappy with a losing security can sell the asset for the loss and reduce taxable income $3,000 this year and allow any additional losses to roll over to be used in future years.
This tax method can generate greater returns.
Consider the investor that saves $720 in taxes each year with tax-loss harvesting. If that individual takes the tax savings and reinvests it diligently in the stock market each year, the money could grow to a sizable sum. Here’s how to implement this strategy: The investor buys shares worth $720 in an exchange-traded fund annually, the amount of the tax savings from the tax loss harvesting strategy, and earns an average return of 7 percent a year. After 25 years, this annual stock fund purchase could grow to more than $41,000.
This strategy only works well for certain income levels.
Tax-loss harvesting isn’t appropriate for retirement accounts, such as a 401(k) or an individual retirement account, known as an IRA, because losses generated in this type of account can’t be deducted. Additionally, unless taxable income is more than $77,200 for a married couple filing joint status or $38,600 for a single filer, tax-loss harvesting makes no sense, says Mark Wilson, president at MILE Wealth Management in Irvine, California. That’s because as of 2018, the long-term capital gains rate is zero for single filers making up to $38,600 and married filing joint taxpayers making up to $77,200.
Investors should sell stocks after analysis.
Mark Painter, president at EverGuide Financial Group in New Jersey, points out a peril of tax-loss harvesting. One might sell a stock or fund only to watch the security rebound the following month. To minimize this problem, Painter suggests avoiding selling around earnings releases. This is because earnings news can impact asset prices greatly. For example, a losing stock might beat earnings expectations and suddenly rebound. Another way to avoid the angst of selling only to watch a stock quickly rebound: Sell a security after analysis, for legitimate reasons, not solely for tax purposes.
Need-to-know facts about tax-loss harvesting.
To recap, here are a few considerations investors should weigh when it comes to tax-loss harvesting:
— Capital gains may be offset.
— Tax-loss selling may generate additional a return.
— The wash-sale rule doesn’t allow tax deductions on certain sells.
— Tax-loss harvesting strategies might reduce a tax bill.
— This tax method can generate greater returns.
— This strategy only works well for certain income levels.
— Investors should sell stocks after analysis.
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