2022 has been a bad year for most markets, but that could create opportunities for tax-loss harvesting. Tax-loss harvesting can provide a way to save up on your taxes, but you need to do it before the calendar year ends.
How Tax-Loss Harvesting Works
U.S. tax payers can offset $3,000 of investment losses against their taxable income, or even carry the loss forward to a future tax-return. These losses can offset investment gains too.
However, for a loss to be realized for tax, it can’t just be a paper loss, it must be sold. Even if you plan to hold investments for the long-term, selling some losing investments before the year end may reduce your tax bill. Also note that if you’re married and filing separately, the amount of losses that you can offset against taxable income is lower at $1,500.
Of course, you may not want to exit the markets just to realize a tax benefit. However, you don’t necessarily have to. When you sell an investment an realize a taxable loss, you can buy something else at the same time, provided it’s not “substantially identical” in the eyes of the IRS.
So if you sold Coke shares for a loss, you could switch the money into Pepsi. Just because you’re selling, doesn’t mean you need to leave the proceeds in cash. If you’re selling an Exchange Traded Funds (ETF) then you could buy one from a different provider, or one that tracks a different index.
Avoiding Wash Sales
Still you can’t just sell an investment and buy it back right away. You must not have bought the same investment within the window 30 days before and 30 days after you’ve sold it.
If you do that it’s called a wash sale, and the loss won’t count for tax purposes. So before you sell, make sure you haven’t purchased the same security in the last 30 days and make a note not to buy it again until 30 days have elapsed.
It can also be helpful to look to harvest shorter-term losses for tax purposes, those are investment that you’ve held for under a year.
Taxable Accounts Only
Bear in mind that tax-loss harvesting is generally only useful in taxable accounts. If you have a tax-sheltered account like an IRA or 401(k) then optimizing for capital gains taxes is typically not useful. That’s because in those types of accounts, you won’t be taxed on capital gains and hence there’s unlikely to be any benefit from tax-loss harvesting.
What’s The Benefit?
You may think you’re going to see investment losses at some point anyway, so what’s the point of tax-loss harvesting?
There are a few benefits. First off pulling your losses forward to today, can help lower your tax bill, then you can earn a return on that money you would have paid in tax.
Secondly, you may not need to sell in the investment for a while, and perhaps you’ll be in a lower tax bracket when you do perhaps when you’re in retirement and paying less tax, so realizing the loss today creates a benefit over your lifetime.
Researchers have also identified a January effect. This is where small cap stocks can outperform the broader market at the start of January. Some believe this could be related to tax-loss harvesting.
It’s common to tax-loss harvest in December, which often means buying investments back in January. If you sell earlier than that, they you may be able to avoid missing out on the January effect, which can offer a small boost to returns for certain stocks, if history is any guide.
It can be very hard to beat the financial markets. However, optimizing your portfolio for tax is a lot simpler, and tax-loss harvesting is one way to help do that.