It Is Not Too Late for Tax Loss Harvesting
How you can still cut your tax bill for 2022 with the use of tax loss harvesting
If a portfolio is adequately diversified (and in some cases, even if it’s not), not every investment is a winner every year. Fortunately, even when an investment experiences a loss, it can still be an opportunity to lower your tax liability and reposition your portfolio for the future. This is done through a strategy called tax loss harvesting. Tax loss harvesting can be particularly useful in years like 2022 where many different types of investments have experienced a loss. Tax loss harvesting generally works like this: an underperforming investment is sold at a loss, generating what the IRS calls a Capital Loss. The proceeds from this sale are used to purchase other securities that are a good fit within your portfolio asset-allocation. The losses created by the original sale are then used to offset other Capital Gains that have occurred within the portfolio. If losses exceed gains for the year, a net Capital Loss of up to $3,000 may be used to lower ordinary income (like W-2 income from employment). If losses in a year are great enough to fully offset gains and reduce ordinary income by $3,000, excess losses may be carried forward to offset income in future years. Despite its relative simplicity on the surface, tax loss harvesting comes with certain pitfalls investors stumble into when trying to execute the strategy. As with any seemingly beneficial tax strategy, the IRS has implemented rules and limitations that must be followed. There is a restriction against what are called “wash-sales” that involve selling an investment solely for the purpose of generating a loss, only to repurchase the security within 31 days of the original sale. This means if an investor were to sell an investment to capture a loss only to turn around the next week and purchase the same investment, the IRS will disallow the loss and exclude the investor from the tax benefits of the loss. As noted above, there are rules regarding what type of income investment losses may offset. Long term capital losses must offset long term gains first, and likewise short-term losses offset short term gains first. Any additional net losses (long-term or short-term) may go to offsetting gains of either type. Again, only in the case where there are enough losses created to offset all the capital gains for a tax year, up to $3,000 of the losses may then be used to offset ordinary income in that tax year and the rest of the losses are carried forward to future tax years. It’s important to note that tax loss harvesting is only available within taxable brokerage accounts. It’s not possible to tax loss harvest 401(k), IRA, 403(b), or other tax deferred accounts. This is because the buying and selling of investments in these types of accounts are not deemed taxable events and therefore do not create any tax benefit from selling investments at a loss. This strategy is best suited for individual or jointly held taxable brokerage accounts, trusts, etc. Consider this example illustrating how tax loss harvesting can lower your tax bill. Let’s say you have investment A that you sell in 2022 for a $20,000 short-term capital gain. The taxes owed on this transaction assuming you are in the 32% tax bracket would be $7,000 ($20,000*35% = $7,000). Now let’s say in the same year you also purchased investment B that is now down $25,000. You could pay the taxes on investment A that was sold for a gain and hope that investment B in the future regains its value and can be sold for a gain, or you could use investment B in the current year for tax loss harvesting. If harvested, you would then realize the $25,000 loss for selling investment B. These short-term capital losses would offset the $20,000 gain from investment A. Additionally, $3,000 of the remaining $5,000 loss would be allowed to offset ordinary income and $2,000 would be carried forward to offset gains in future years. Ideally, the proceeds from selling investment B would be placed to work into another investment to generate future gains. The total current year tax savings from this tax loss harvesting would be $8,050 ($3,000*32% = $1,050 + $7,000 = $8,050), and you would carry additional tax savings into the next tax year. Tax loss harvesting requires a thorough understanding of tax regulation and investment strategy, so we recommend that you consult a tax expert and financial planner before conducting this strategy. Rhame & Gorrell Wealth Management has deep expertise in tax loss harvesting as well as other tax and investment matters.
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If you’d like some help from a CPA or CERTIFIED FINANCIAL PLANNER (CFP®) advisor regarding this strategy and how it applies to you, the Rhame & Gorrell Wealth Management team is here to help.
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