Tax Loss Harvesting is a financial strategy designed to lower taxes on capital gains. Investopedia.com defines the process as “...deliberately selling an investment at a loss—i.e., deliberately taking a capital loss—in order to use that loss to offset taxes owed on an investment sold at a profit—i.e., a capital gain—or even taxes owed on personal income. “.
Tax Loss Harvesting can also be used to offset gains in the current year, can be carried forward to offset future gains, or to be used as an income tax deduction (up to $3000). There is a limit on the allowable capital loss deduction as determined by Schedule D (Form 1040) and is the lesser of:
- $3,000 ($1,500 if you are married and file a separate return)
- Your total net loss as shown on line 16 of Schedule D (Form 1040).
Per the IRS, one can use the total net loss to reduce your income dollar for dollar up to the maximum $3,000 limit. Tax Loss Harvesting is only applicable on taxable investment accounts, not qualified retirement accounts such as Roth IRAs or 401ks.
Why Should I Use Tax Loss Harvesting?
One of the biggest benefits of using Tax Loss Harvesting is that it can offset taxes on your capital gains. Using capital losses to offset capital gains can lower your taxable income. For example, if an investor had earned a profit of $50,000 in Fund 1 but has a loss of $23,000 in Fund 2, then the taxes that would be owed would be based on the difference between the two funds, not the full profit from Fund 1. In this example, the investor would owe taxes on $27,000 instead of the full $50,000. In this scenario, utilizing Tax Loss Harvesting would allow the investor to minimize tax exposure on nearly half of their capital gains.
Tax Law Harvesting is not for everyone, and there are specific rules that must be followed to avoid penalties. Investors considering Tax Loss Harvesting should consult their financial planning professional and/or tax professional to review their specific financial situation.
Wash Sale Rule
In a concerted effort to prevent investors from taking intentional losses to offset realized gains, the Wash Sale Rule was created. The investing scenario to be aware of that qualifies as a wash sale is described below.
Wash Sale Scenario:
Investors that sell a security at a loss and then repurchase that same security or one that is similar within 30 days of the realized loss.
In order to navigate the potential pitfalls of Tax Loss Harvesting, it is prudent to seek counsel of tax professional in conjunction with your investment advisor to ensure that your strategy is above board and meets the legal requirements. The team at Instrumental Wealth can help you demystify the Wash Sale Rule and assist you in executing a timely, secure plan.
What is Direct Indexing?
Direct Indexing is a strategy where investors own individual stocks that make up a chosen index, such as the S&P 500. By owning the stocks individually, it can give an advantage to investors by giving the opportunity to harvest the tax losses on the stocks that may have a loss. Whereas if the investment is in an indexed fund/ETF may produce an overall gain, despite any individual stocks that have losses.
Schedule an appointment with one of our knowledgeable investment specialists, and we’ll review your investments to determine if Tax Loss Harvesting or other strategies might be right for your individual situation.
Disclosure: One cannot invest directly into an index.
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Instrumental Wealth | What is Tax Loss Harvesting?