It’s the quintessential good-news/bad-news scenario for investors: Some of your investments had a banner year. (High five!) Others? Well, not so much.
Don’t get too down on the losers. Those underachievers may come in handy when it’s time to reconcile with the IRS. Through a strategy called tax-loss harvesting, investments that are in the red can be your ticket to a lower tax bill.
Sell losing stocks and buy a tax break
Tax shelters aren’t just for the rich. Tax-loss harvesting helps everyday investors minimize what they pay in capital gains taxes by offsetting the amount they have to claim as income.
You “harvest” investments to sell at a loss, then use that loss to lower or even eliminate the taxes you have to pay on gains you made during the year.
You don’t have to be a high-roller with a fat portfolio to benefit from an annual portfolio harvest, either. Investors who don’t have investment gains to minimize can use the losses to offset the taxes they pay on their ordinary income too.
First, a word from the IRS
You won’t find any specific reference to “tax-loss harvesting” in the 45,000 words the IRS devotes to investment income and expenses in Publication 550. But that doesn’t mean there aren’t rules governing the strategy. And plenty of them.
- Wash sales rules: Your loss is disallowed if, within 30 days of selling the investment (either before or after) you or even your spouse invests in something that is identical (the same stock or fund) or, in the IRS’ words, “substantially similar” to the one you sold.
- Cost basis calculations: Unless you purchased your entire position in a stock, mutual fund or ETF at a single time, the price that you paid for the investment varied. Good records of every purchase are required in order to come up with the proper cost basis to report to the IRS.
If your head already hurts, you’re not alone. (There’s a reason why NerdWallet gives a hat-tip to online advisors that do the behind-the-scenes tax work for investors: It’s not an easy task.) Still, every investor should learn the basics of tax-loss harvesting in order to decide if it’s a worthwhile strategy to employ.
Here’s a rundown of key things to know:
1. It applies only to investments held in taxable accounts
The idea behind tax-loss harvesting is to offset taxable investment gains. Because the IRS does not tax growth on investments in tax-sheltered accounts — such as 401(k)s, 403(b)s, IRAs and 529s — there’s no reason to try to minimize your gains. As long as all that money remains within the tax force field those accounts provide, your investments can generate buckets of cash without Uncle Sam coming around asking for his take.
2. It’s not as financially fruitful if you’re in a low tax bracket
Since the idea behind tax-loss harvesting is to lower your tax bill today, it’s most beneficial for people who are currently in a high-ish tax bracket.
For example, if you’re in the 25% federal income tax bracket and you have $3,000 in losses you can use to offset your other income, you’ll save a whopping $750 in taxes this year. Obviously, the higher your income tax bracket, the bigger your savings.
If you’re currently in a lower tax bracket and expect to be in a higher tax bracket in the future (via well-deserved promotions at work, or if you think Uncle Sam will raise tax rates), you might want to save the tax-harvesting until later when you’ll reap more savings from the strategy. (Also see No. 7 below for another reason you shouldn’t jump to tax-loss harvest too soon.)
3. If you’re going for it, you have only until Dec. 31
Procrastinators take note: Some investing homework — such as opening and funding an IRA — can be made up until the April tax filing deadline. However, there is no such grace period for tax-loss harvesting.
You need to complete all of your harvesting before the end of the calendar year, Dec. 31. So set that egg timer and get to work.
4. It’s most useful if you’re investing in individual stocks, actively managed funds and/or exchange-traded funds
Index fund investors typically find it difficult to employ tax-loss harvesting in their portfolios. However, if you’re indexing using ETFs or mutual funds that focus on a particular niche (a sector, geographic area or market cap, for example), it’s a different story.
That’s where investing via a robo-advisor comes in handy. Robo-advisors do much more than simply build and manage well-rounded portfolios for customers. Most of them also serve as tax police keeping a 24-7 watch for opportunities to minimize taxes and offset gains.
No need to harvest your own field (or hire a CPA or financial whiz familiar with every word of the IRS tax code) when you’ve got a sophisticated algorithm scouring your portfolio and running it through all sorts of tax and investing scenarios for you.
5. You must keep your apples and oranges straight
The taxes you pay on gains are based on the length of time you’ve owned the investment. According to IRS holding-period rules:
- Long-term capital gains tax rates are applied when you sell an investment that you’ve held for one year or longer. The IRS rewards you for your patience by taxing you only 15% to 20% on your gains (or less if you fall into the lower tax brackets).
- Short-term capital gains tax rates kick in when investors sell something that they’ve held for less than one year. The tax rate for short-timers equals your ordinary income tax rate. So if you’re in the 28% tax bracket, that’s how much you’ll pay on these gains.
Besides the difference in how big of a tax hit you’ll take, there’s an important reason to pay attention to the distinction: The IRS checks your homework when you file Schedule D to report your capital gains and losses.
6. The upside of losing is limited to $1,500 to $3,000 a year
Investors are allowed to claim only a limited amount of losses on their taxes in a given year. For the 2016 tax season, the cap is $3,000 (except if you’re married and filing separately, in which case you are allowed up to $1,500 to offset taxable income).
That said, if you had a particularly brutal year (our condolences) and racked up more investment losses than the limit, don’t fret: You can apply the overage to offset capital gains in 2017 and however many other years it takes until you’ve used up the entire amount.
7. Don’t sell your losers just to get the tax break
Don’t become overzealous as you scour your portfolio for investments to harvest for tax losses. The purpose of investing in stocks is to achieve long-term growth that beats the returns produced by other assets (like bonds, CDs, money market funds and savings accounts). In exchange for outperformance you have to put up with exposure to short-term volatility.
Unless there’s something fundamentally wrong with the investment that has caused it to lose value, you’re better off holding on and letting time and the magic of compound interest smooth out your returns.
8. Put the cash from the sale to good use
There are immediate benefits of tax-loss harvesting, such as lowering your tax bill for the year. However, more important are the medium- to long-term payoffs that you can get if you invest the money you freed up in something better.
If you do decide to sell, deploy the proceeds thoughtfully. Use them to rebalance your portfolio if your asset allocation has gotten out of whack. Invest in a company that you have on your watch list; buy into an ETF or mutual fund that gives you exposure to a sector or asset class that you currently lack; or add to an existing position you believe still has great potential.
Image via iStock.