Is tax loss harvesting a smart strategy for you?

What is tax loss harvesting and how does it work?

Tax loss harvesting is a strategy used by investors to minimize tax liabilities by selling investments that have decreased in value, which can offset gains from profitable investments. The process involves using capital losses to reduce the amount of taxes owed on any gains from other investments. For example, if you earned $5,000 in gains but also had $2,000 in losses, you’d only pay taxes on a $3,000 net gain.

If your losses exceed your gains, you can offset up to $3,000 of your ordinary income per year and carry forward any remaining losses to future years. Keep in mind that tax loss harvesting must follow IRS rules, such as the “wash sale rule,” which prohibits repurchasing the same or substantially identical securities within 30 days before or after the sale of the loss-generating asset.

In what circumstances is tax loss harvesting a smart strategy?

Tax loss harvesting is particularly useful if you’ve sold investments at a profit during the year. This strategy can help reduce or eliminate taxes owed on those gains, which is especially valuable if you’ve had significant profits from stocks, mutual funds, real estate, or other taxable investments. It’s even more beneficial if you’re in a high tax bracket, as the higher your income tax bracket, the more tax loss harvesting can reduce your taxable gains and offset up to $3,000 of ordinary income.

Tax loss harvesting also offers an opportunity to improve your portfolio’s efficiency. If you hold underperforming assets, this strategy allows you to exit those positions and rebalance your portfolio while taking advantage of tax benefits. During market downturns or periods of increased volatility, you can take advantage of widespread losses, realize them, and reinvest in similar (but not identical) securities to maintain exposure while reducing your tax liability.

Additionally, if your capital losses exceed your gains, tax loss harvesting still provides value by offsetting up to $3,000 of ordinary income each year, with the remaining losses carried forward to future years. This can be particularly useful if you anticipate higher income or capital gains in the future.

For those nearing retirement or going through significant life transitions, such as selling a business or exercising stock options, tax loss harvesting can help preserve wealth by reducing the tax impact of these events, leaving you with more of your investment gains.

Situations when tax loss harvesting is less than ideal

However, tax loss harvesting may not always be ideal. If you’re in a low tax bracket the benefits may be minimal since long-term capital gains could already be taxed at 0%. Additionally, if an investment is expected to recover soon, selling it to lock in a loss may not be necessary. It’s also important to be mindful of the wash sale rule: if you repurchase the same or a substantially identical security within 30 days before or after selling it, the tax benefit may be disqualified.

Overall, tax loss harvesting can be a smart tool for reducing taxes and improving investment returns, particularly in volatile market conditions and depending on your specific situation. However, it’s always advisable to consult with a tax professional to ensure compliance and determine if this strategy is right for you.

For further guidance, feel free to contact Davis & Hodgdon CPAs at 802-878-1963 (Williston) or 802-775-7132 (Rutland).

Before making any decisions, it’s important to consult with a tax professional to ensure this strategy is right for you.