Even in a bull market, not every investment will be a winner. With the right tax strategy, a losing investment can have a silver lining.
You may be able to capture a loss on a stock to:
- lower your tax liability
- better position your portfolio for future gains.
This strategy is called tax-loss harvesting, and it’s one of the many tax strategies that investors should consider.
Tax-loss harvesting generally works like this:
- You sell an investment that’s underperforming and losing money.
- Then, you reinvest the money from the sale into a different security that meets your investment objectives and asset-allocation strategy.
- Finally, you can use the loss from the security you sold to reduce future taxes when you offset future capital gains on the sale of an investment. You may also use it to offset up to $3,000 of your ordinary income each year.
While the general principle behind tax-loss harvesting is straightforward, there are some common pitfalls that are important to avoid.
The basics of tax-loss harvesting
Let’s pretend that you are reviewing your investments, and you see that your energy holdings have risen sharply while some of your automotive stocks have dropped in value. As a result, you now have too much of your portfolio’s value exposed to the energy sector. In order to rebalance your portfolio, you sell some of your energy stocks and use those funds to invest in other stocks. When you sell the energy stocks, you realize a significant taxable gain.
This is when tax-loss harvesting can be used to lower your tax liability.
If you also sell the automotive stocks that have declined in value, you could use the losses on this sale to offset the capital gains from the sale of the energy stocks, thereby reducing your tax liability.
Definitions:
Long–term capital gain is the gain from the sale of an asset that you owned for more than a year before you sold it. A long–term capital loss is the loss from the sale of an asset that you owned for more than one year. Long-Term capital gains tax rates range from 0 to 20%, depending on your income.
Short–Term Capital gain is the gain from the sale of an asset that you owned for less than one year. A short–term capital loss is the loss from the sale of an asset that you owned for less than one year. A short-term capital gain will be taxed at the higher ordinary-income rates.
What if your losses are larger than the gains? You can use the remaining losses to offset up to $3,000 of your ordinary taxable income (for married couples filing separately, the limit is $1,500). Any amount over $3,000 can be carried forward to future tax years to offset income down the road.
For example, let’s say you recognize a gain of $20,000 on a stock you bought less than a year ago (Investment A).
At the same time, you also sell shares of another stock for a short-term capital loss of $25,000 (Investment B). Your $25,000 loss would offset the full $20,000 gain from Investment A, meaning you’d owe no taxes on the gain, and you could use the remaining $5,000 loss to offset $3,000 of your ordinary income. The leftover $2,000 loss could then be carried forward to offset income in future tax years.
Using an investment loss to lower your capital-gains tax
By offsetting the capital gains of Investment A with your capital loss of Investment B, you could potentially save $7,000 on taxes ($20,000 × 35%). Because you lost $5,000 more than you gained ($25,000 – $20,000), you can reduce your ordinary income by $3,000, potentially lowering your tax liability an additional $1,050 ($3,000 × 35%) for a total savings of $8,050 ($7,000 + $1,050). You could then apply the remaining $2,000 of your capital loss from Investment B ($5,000 – $3,000) to gains or income the following tax year.
Issues to consider before utilizing tax-loss harvesting
As with any tax-related topic, there are rules and limitations:
- Tax-loss harvesting isn’t useful in retirement accounts, such as a 401(k) or an IRA, because you can’t deduct the losses generated in a tax-deferred account.
- There are restrictions on using specific types of losses to offset certain gains. A long-term loss would first be applied to a long-term gain, and a short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type.
- When conducting these types of transactions, you should also be aware of the wash-sale rule, which states that if you sell a security at a loss and buy the same or a “substantially identical” security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes.
No Expiration Date on Capital Losses: In the example above, the investor can use their capital loss of $5,000 dollar for dollar to offset their entire capital gain of $2,000 this year—and the remaining capital-loss balance of $3,000 can be carried over to offset future capital gains (or income) until it is used up—there is no expiration date. In fact, even if the investor had no gains to offset that year, any capital losses they decided to harvest would carry over to future years until they are needed.
Financial Services for Real People
Founded for the benefit of clients, Echelon Financial is an independent Austin-based firm with a deep commitment to providing guidance that is free of conflicts of interest, based solely on the sum of our experience and expertise. We are committed to putting client interests first and to stewarding both wealth and well-being for those we serve. We have a singular measure of success: the results we get for our clients.
To learn how to optimize your Social Security, we’re offering a FREE Retirement Assessment to review your taxes, investments, and current financial strategies.
Schedule a FREE Assessment Today!
Informational Brochure: Echelon Financial is a member firm of The Fiduciary Alliance, LLC which is an Investment Adviser registered with the Securities and Exchange Commission. The Fiduciary Alliance’s business operations, services, and fees is available at the SEC’s investment adviser public information website www.adviserinfo.sec.gov or from The Fiduciary Alliance upon request.
This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax professional.
Echelon Financial is a member firm of The Fiduciary Alliance, LLC which is an Investment Adviser registered with the Securities and Exchange Commission. The Fiduciary Alliance’s business operations, services, and fees is available at the SEC’s investment adviser public information website www.adviserinfo.sec.gov or from The Fiduciary Alliance upon request.
