April 23, 2020 Update: Lower Your Tax Bill Through Tax-Loss Harvesting
By Paul Hynes, CFP®
There can be a silver lining in the storm clouds of market declines. It comes by offsetting capital gains with capital losses in order to reduce overall gains and thus reduce future taxes.
In down markets such as these, there may be investments in your portfolio that are valued at less than their original cost. When this happens, you have what’s called an unrealized loss. If you sell the investment, the loss becomes realized. You can only use realized losses to offset realized gains, and to a limited extent, also offset other income. Be sure to obtain advice about any tax strategies from your own tax advisor, this strategy and the examples below should not be considered tax guidance.
Here’s how it works: Suppose you paid $10,000 for investment X, which is now worth $7,000. You sell investment X at a loss and replace it with investment Y. Now, you have a realized loss of $3,000.
So, how could this help you lower your tax bill? Let’s say you have $3,000 of realized capital gains from sales earlier in the year. You offset the gains (+$3,000) with the losses from selling investment X (-$3,000) ending up with zero taxable gains. That could save you $450 in federal taxes (at a 15% rate, if the gains were long-term), and an additional savings in state taxes. If you live in California, where there’s no preferred tax rate on long-term gains, you might easily save another $279 (at the 9.3% state tax rate). That’s a total of $729 in tax savings.
If you don’t have any gains to offset, the IRS allows you to deduct up to $3,000 of losses against ordinary income. That can save you as much as $720 in federal taxes (at the 24% rate) and $279 in state taxes (at the 9.3% rate), for a total of $999 in tax savings.
When losses exceed gains in any single year, you can carry the losses forward to future tax years. The losses won’t expire, and you can continue to use them to offset gains, or deduct the $3,000 against ordinary income, until they’re used up.
Be forewarned: when realizing losses, there’s a potential trap to watch out for called the “wash sale rule.” The IRS won’t allow you to sell investment X and then immediately buy back investment X and still realize a loss. If you buy the same investment, or one that is substantially identical, within 30 days either before or after, the transaction might be considered a wash by the IRS. In which case, the loss wouldn’t be recognized.
The example above assumes zero transaction costs, which might not be the case. So, you not only need to watch out for the wash sale rule, you should also consider whether the cost might eat away too much of your tax savings.
At HearthStone, we will typically do the loss harvesting for our clients if it makes sense. We know that a tax-penny saved is a penny earned, and harvesting tax losses can be a way to regain some ground during market declines. Talk with us about this or anything else that’s on your mind. We’re here to help.
Resource: IRS Topic No. 409: Capital Gains and Losses can be found here.