EP 31 Tax-Loss Harvesting
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Welcome back to Money Matters where I help guide you in becoming a better and a more confident investor. In this week’s instalment I wanted to touch on tax-loss harvesting. What is it, when it’s a good idea, how’s it applied, and is it right for you? With that being said let’s get into it.
In the book Thinking Fast and Slow, Daniel Kahneman touched on this idea of loss aversion – stating that humans suffer twice as much emotional repercussion in pain when dealing with a loss than one would in emotional joys that a gain would bring. With that in mind, then why would an investor sell their assets while they’re down capturing a loss then? This is where Tax-Loss Harvesting comes to play. Allow me to explain.
Tax-Loss Harvesting is the practice of selling a security that has experiences a loss and you either let that go to cash, or replace it with a similar security with the idea that come tax time you will be able to apply those losses against any realized gain or income that you’ve received during that same tax year with the basic idea being to help lower your tax consequence of any gains or income come Tax Day on April 15th that following year. Note that you can’t take losses in a tax-deferred account such as an IRA, so this strategy of tax-loss harvesting will only apply to taxable accounts. Also note, that losses can offset gains dollar of dollar in a given year, and then additional losses can be carried forward $3,000 a year indefinitely to offset future realized gains. For example – If you have a say $50,000 gain in 2020, and by years end you have a $70,000 loss that was generated. So all in all – you have a $20,000 net loss. In this case the $50,000 gain is wiped out by the $50,000 loss dollar for dollar, so there’s now no tax consequences that you must pay on those gain. And, that additional $20,000 loss will be carried forward to offset future gains, or if there are no gain in 2021, then you can use $3,000 to offset income. And every year you will use the negative balance until it’s used up.
If you’re looking at your account and you’re seeing some read, or those on paper losses, then you may be thinking when is it a good time to implement this strategy? There are many situations where tax-loss harvesting would benefit your overall objectives, but let’s go over a few opportunities to consider first.
When years end, or December 31st is approaching and you’re looking over your entire portfolio’s taxable returns and you’ve already realized a capital gain from a sale. In this case your holdings that are trading at a loss can be sold to mitigate or eliminate that capital gains tax liability.
If you’re annually rebalancing your portfolio this is a great opportunity to pair any losses with gains when you bring your allocation back to where you started at the beginning of the year.
How do these losses apply to your taxes?
Once you’ve sold or realized your loss from selling a depreciated security, we now know that it can now be used to offset your capital gains and potentially your income in that given year. Losses however must be paired like-to-like meaning that long-term losses are applied to long-term cap gains, or assets held for over a year, and the same for short-term losses and capital gains, which is assets held under a year. And then after the offsetting your capital gains, you can then deduct up to $3,000 of capital losses on your ordinary income if you’re married filing jointly. $1,500 if your single, and then carry those losses forward as previously discussed.
Tax-loss harvesting is a strategy that should not be overlooked, and certainly not ignored. Done properly overtime has the potential to save you a considerable amount in taxes owed. Here at Colby Financial Guidance this is something that we are always taking into account for any taxable account we manage. If you have questions, or find you don’t want to go at this decision alone I invite you to give me or someone on my team a call as we’d gladly provide guidance on the topic. I thank you for watching and as always thanks you for giving your finance the attention that they deserve!
