Before we go any further you have to understand some basic concepts…
What is a capital loss? A capital loss occurs when you sell any asset (ie: stock, ETF, mutual fund, etc.) at a loss. In other words you read the tea leaves wrong, or the monkey threw the dart poorly, or whatever metaphor you want to use, and now you are paying the price.
What is a capital gain? A capital gain occurs when you sell an asset for a gain. In other words you buy something and it goes up in value. Don’t think for a minute that you get to keep all that gravy… Uncle Sam wants his share of the “gained” money. This is what a capital gains tax is! As Benny Franklin said, “there are two certainties in life: death and taxes.”
With that understanding we can discuss tax loss harvesting. At its core, tax loss harvesting involves selling an underperforming investment at a loss and using that loss to offset capital gains realized from other investments. This process can help to reduce an investor’s overall tax burden, as capital gains taxes are only applied to the net gains after accounting for the losses. In other words, tax loss harvesting allows investors to turn an unfortunate situation, such as a declining stock value, into a financial advantage.
Step-by-step explanation of how tax loss harvesting works:
- Identify underperforming investments: Review your investment portfolio and pinpoint any assets that have experienced a decline in value. These losses may be eligible for tax loss harvesting.
- Sell the underperforming investment: By selling the investment at a loss, you can now use that loss to offset capital gains realized from other investments, effectively reducing your overall tax burden.
- Reinvest the proceeds: It is important to reinvest the proceeds from the sale of the underperforming investment into a similar, but not identical, asset. This is to avoid the “wash-sale rule,” which prevents investors from claiming a tax loss if they repurchase the same or a substantially similar investment within 30 days before or after the sale. By reinvesting the proceeds, you can maintain your desired asset allocation and continue to work towards your financial goals.
- Report the loss on your tax return: When filing your taxes, you will need to report the capital loss from the sold investment. This loss can be used to offset capital gains from other investments, reducing your overall tax liability.
Let’s work through this in a hypothetical scenario…
Joe has a stock that he bought for $100. The stock plummets to 1 dollar representing a loss of $99 and his wife is pissed. He sells the stock taking it on the chin like a man. Fortunately, he bought another stock for $100 and the stock increased in value to $199. He sold that stock and netted a profit of $99 so his wife is not nearly as pissed now. He now has a net loss of $99 and a net gain of $99 meaning he owes NO taxes on the gains from the winning stock.
However, had he not sold the losing stock and instead only sold the winning stock he would owe capital gains on the $99 win. In a perfect world he would reinvest that one dollar on the losing stock into another stock and watch it ride the market back up (assuming he is good at picking stocks, which his wife is not so sure of yet). If he is not good at picking stocks, and most people are not, he should read our article on the wisdom of the Bogleheads.
Tax loss harvesting is what large corporations do to minimize their tax burdens for years potentially. This is why some companies have almost zero tax burden in some years because they are using losses from prior years to offset gains from current years. Donald Trump, love him or hate him, used this to his advantage very well.
Just a Little History Bomb on Taxation (Stamp Act of 1765)
If you had a particularly horrendous year in the stock market and your wife is now contemplating divorce, you can say, “hey babe, I can use some of these losses against our earned income taxes.” It may not keep her from divorcing you, but, hey, at least you tried. Please note that only $3000 per year of capital losses can be deducted against ordinary income. The nice thing is that remaining losses can be held over to the subsequent tax years in perpetuity.
It’s important to note that tax loss harvesting is most effective for investors with taxable investment accounts, as tax-advantaged accounts, such as 401(k)s and IRAs, have different tax treatment rules. Moreover, tax loss harvesting is subject to certain limitations, such as the annual $3,000 limit on net capital losses that can be deducted against ordinary income.
In conclusion, tax loss harvesting is a valuable strategy for investors seeking to minimize their capital gains tax liability and maximize their investment potential. By implementing tax loss harvesting in a thoughtful and strategic manner, investors can leverage their losses to achieve their long-term financial goals more effectively. As always, it is advisable to consult with a financial advisor or tax professional to ensure you are implementing this strategy in a manner that is compliant with tax regulations and aligned with your specific financial situation.
More Financial Advise to (Hopefully) Keep Your Wife Happy…