Debating Taking End of Year Investment Losses? Avoid Making These Costly Mistakes

Pra-chid / Getty Images/iStockphoto
Pra-chid / Getty Images/iStockphoto

With two and a half months to go until the end of the year, it is not too early for investors to think about underperforming assets in a down market and about how to lower their 2022 tax consequences.

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Although you should be aware of market dips and looking for potential investment opportunities when they occur, most people make moves nearing the end of the year, specially when it comes to strategies like tax loss harvesting.

By offsetting capital gains with tax loss harvesting, investors can sell securities at a loss to counteract tax liabilities. If losses exceed gains, taxpayers can use up to $3,000 a year to offset ordinary income on federal income taxes. Losses in excess of $3,000 can be carried over year after year to offset future gains.

Sounds simple enough, but every financier should be mindful of pitfalls attached to the selling and reinvesting of assets associated with tax loss harvesting. Below are three things to avoid when harvesting your tax losses.

1. Don’t Let Tax Loss Harvesting Rule Ruin Your Investment Strategy

Sure, avoiding capital gains taxes is a smart approach, but selling just to take a tax loss shouldn’t cloud your judgment and put your overall investment strategy at risk. Just because you can harvest tax losses doesn’t mean you have to. Keeping an asset that you think will be a long-term winner might trump trading it away.

Additionally, as U.S. News & World Report stated, some stocks and bonds in your investment mix may act as advantageous “portfolio diversifiers” that reduce the risk to your portfolio and can potentially add a return without relying on an individual security. Selling them may damage your portfolio overall.

2. Don’t Forget To Plan for Reinvestment

Selling stock at a loss for tax purposes and letting it sit in cash serves little purpose when choosing to harvest. Take the time to figure out where you should reinvest your money. As Zoe Financial pointed out, “The critical component to tax loss harvesting is that you stay invested in the market.”

Again, selling just for the sake of it brings no value to your investment collection. Buying useful replacement investments will grow your portfolio and put you in a position to strike when the market picks up.

3. Don’t Trigger the Wash Rule

To deter investors from selling their losing securities just to claim a quick tax deduction, the wash rule prevents investors from buying a substantially identical asset 30 days before or after the sale of the funds chosen when conducting tax loss harvesting (Note: The wash-sale rule is in effect for a 61-day window because the rule applies to 30 days before and 30 days after the sale transaction).

By offsetting your loss by buying substantially identical securities, it is considered a “wash” and you are not entitled to a loss deduction.

But what constitutes “substantially identical” assets or securities? According to The Balance, this vague description is outlined in the IRS’s lengthy Publication 550. Generally, the rule applies to an investor that:

  • Purchases the same investment.

  • Purchases a substantially similar investment.

  • Enters into a contract to buy a similar investment.

  • Acquires a similar stock for an IRA or Roth IRA.

This doesn’t mean the investor has to reinvest in a completely different industry. For example, if an investor sells tech company stock to harvest a tax loss but wants to have tech sector assets represented in the portfolio, the investor could replace the loss stock with a technology index fund or a tech exchange traded fund (EFT).

It is important to note two more things about the wash rule:

First, as Forbes pointed out, selling an investment for a loss in a taxable account, then buying the same investment inside an IRA, won’t work. Even though an IRA is a different asset type, it still will trigger a wash rule violation if the purchase is made within 30 days of the sale. This applies to both traditional and Roth IRAs.

Second, having a spouse buy an investment at the same time you sell an asset for a loss within the 61-day period will not enable you to bypass the wash rule. As MarketWatch pointed out, according to the Publication 550, this is regardless of whether you file jointly or separately.

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By keeping your investment strategy in focus, planning your reinvestment wisely and avoiding breaching the IRS’s wash-sale rule, harvesting is a year-end loss strategy that can lead to tax-time returns.

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This article originally appeared on GOBankingRates.com: Debating Taking End of Year Investment Losses? Avoid Making These Costly Mistakes