As you approach the end of the year, you have one last chance to offset investment gains in your taxes. Short-term capital gains are subject to high taxes, but you can defray some of this by using tax loss harvesting. This balances your gains with losses and reduces your total tax liability.
What Is Tax Loss Harvesting?
Tax loss harvesting is the selling of securities that have lost value in order to offset your tax liability from any capital gains you have made this year. This way, your total capital gains will be lower, and your tax liability will decrease.
It also can offset any income, even if you haven’t made income from capital gains. Any time your losses are greater than your gains, you can use the remaining losses to offset regular income up to $3,000.
How to Use Tax Loss Harvesting
Any time you have investments that are losing money, you can sell them to offset your gains. For instance, if you sold a stock this year for a gain of $10,000, you can search for a stock that has underperformed this year and sell it at a loss. If, for instance, you lose $5,000 on the sale, your capital gains tax liability is reduced to $5,000.
Alternatively, say you’ve gained $5,000 by selling a successful investment and lost $10,000 by selling a poorly-performing stock. In this case, you now have no capital gains tax liability. Plus, you can put $3,000 of the loss toward offsetting your regular income.
Once you’ve done that, it’s wise to buy a similar security of the same value in order to keep your portfolio balanced.
Limitations on Tax Loss Harvesting
By IRS regulations, there are some limits to what you can do with tax loss harvesting. First, by the wash sale rule, you can’t deduct losses from gains on the same security. That means you shouldn’t reinvest your money by buying the same stock you just sold.
Next, losses on short-term investments are applied first to offset gains on other short-term investments, and long-term losses on long-term gains. Only after offsetting gains of the same type can those losses be applied to other kinds of gains.
Investment losses can only offset $3,000 of regular income, even if you have more than $3,000 worth of losses.
Tax loss harvesting isn’t useful on retirement investments, since losses in a 401(k) or IRA aren’t deductible.
And, of course, every transaction you make will cost you money. Is the tax write-off worth more than your transaction fees? If not, don’t bother.
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