What Tax Loss Harvesting Is and How to Use It to Reduce Gains
No one invests in the stock market hoping to take a loss. However, the downside of taking profits in the stock market is that you might owe taxes on your gains. Tax loss harvesting is a way to strategically use any losses you might have to lower your tax bill. Tax loss harvesting strategies are completely legal and a good way to help reduce your gains. However, you’ll have to follow IRS tax loss harvesting rules when you’re filing taxes to avoid penalties.
Long-Term and Short-Term Capital Gains
Capital gains come in two types: short-term and long-term. The distinction is important at tax time. Long-term gains are those held for longer than one year, and they come with special, lowered tax rates. Short-term gains are those held for one year or less, and they are taxed at ordinary income tax rates. With the top tax bracket for 2021 coming in at 37%, the total short-term capital gains rate can approach 50% when state capital gains tax is factored in.
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Offsetting Capital Gains
IRS rules can help reduce the sting of capital gains tax, as they allow investors to offset capital gains with capital losses. For example, if you have a stock trading at a $5,000 loss and you’ve already taken a $5,000 gain, you can offset the two and avoid paying any tax on your gain. If you’ve taken more losses than gains, the IRS allows you to offset up to $3,000 in ordinary income as well. If you still have additional losses, you can carry those losses forward to use in future years.
Tax Harvesting Strategies
IRS rules require investors to first offset long-term gains with long-term losses, and short-term gains with short-term losses . Since short-term gains carry the higher tax rate, it makes sense to harvest short-term losses first.
However, financial advisors recommend that you don’t sell a stock just for tax purposes. Harvesting tax losses should be part of your overall financial strategy, where you cull losing stocks from your portfolio if they are no longer suited to your investment strategy.
Take the cost basis of your individual stock positions into account when you harvest losses. If you’ve bought the same stock at different prices, you’ll have a larger gain or loss on each individual purpose. You can choose which lot you want to sell to better match your losses and your gains, perhaps with the help of a tax loss harvesting calculator.
Wash Sale Rules
An important rule to understand when harvesting tax losses is the wash sale rule. If you take a loss on a security, you can’t buy the same or a “substantially identical” security 30 days before or after the sale. If you do, you trigger a wash sale, and your loss on the sale is disallowed. The IRS doesn’t provide a clear definition of what a “substantially identical” security is, however, so if you’re planning on substitution an ETF for a stock, for example, you might want to consult with a tax advisor first.
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Cynthia Measom contributed to the reporting for this article.
Last updated: Feb. 26, 2021
This article originally appeared on GOBankingRates.com: What Tax Loss Harvesting Is and How to Use It to Reduce Gains
