One of the realities of investing is that you generally have to pay taxes when you sell a security or mutual fund at a profit.
If you sell shares of the investment within a year of buying them, your profits will be categorized as short-term capital gains. They’re taxed as ordinary income tied to your specific tax bracket.
If you’ve held the investment for more than a year before you sell, your profits will be counted as long-term capital gains. They’re taxed at either 0%, 15% or 20%, depending on your taxable income.
To reduce or eliminate these taxes, many investors sell shares of certain investments for less than what they paid for them. They can use these capital losses to offset capital gains generated by other sales.
This strategy is known as tax-loss harvesting. And many investors are taking advantage of today's bear market to reap its tax-reducing potential.
A hypothetical example of “zeroing out”
In January 2020, John sold 100 shares of ABC Company, which had appreciated $5,000 in value since he bought them three years ago. To offset the $5,000 long-term capital gain, John sold 200 shares of XYZ, Inc. in April at a loss of $5,000. In terms of net capital gains, these two trades cancel each other out.
Using tax-loss harvesting as a long-term tax-reduction strategy
In a bear market, such as we’re in now, you’re probably finding that many of your stocks are priced far less than what you paid for them. Likewise, you don’t really want to sell your long-term “winners.” So, you might think there’s no advantage in selling these “losers” to generate capital losses when you have no capital gains to offset, right?
There may be some very good reasons to sell them. One of them is that if you don’t use your capital losses to offset capital gains this year, you can use up to $3,000 of these losses to offset your ordinary income, which could potentially lower your tax bill.
Better still, you can carry over your capital losses indefinitely to offset future capital gains or ordinary income until the amount of your original loss is fully depleted.
A hypothetical example of “future carryover”
In March of 2020, Jane generates $20,000 in capital losses by selling some of her losing stocks and mutual funds. Since she didn’t sell any investments at a profit this year, she incurs no capital gains. If she wishes, she can apply $3,000 of her capital losses to lower her adjusted gross income (AGI) in 2020, and carry over the remaining $17,000.
In 2021, she sells some of her stock for a $5,000 profit. She can use $5,000 of her carryover losses to zero out these long-term capital gains, and apply an additional $3,000 to reduce her 2021 AGI. She can then carry over the remaining $9,000 to 2022.
“Rebound” tax-loss harvesting--and wash sale risk
During the current bear market, many investors are selling shares of their losing stocks to generate capital losses they can use for carryover purposes with the intention of repurchasing these shares later—hopefully still at a bargain price—to lock in their future upside potential.
The IRS knows that many investors like to use this “rebound tax-loss harvesting strategy.” That’s why Uncle Sam prohibits people from using capital losses from a sale if they repurchase the same security within 30 days. If you do this, the IRS flags this as a wash sale and your loss is added to the cost basis of the shares you’ve repurchased.
The IRS even applies the wash sale rules if within 30 days you buy a security it deems to be “substantially identical” to the one you sold. For example, if you sold shares of an S&P 500 index mutual fund at a loss and bought shares of an S&P 500 index ETF ten days later, the IRS could declare this a wash sale since the funds’ investment strategies are nearly identical.
One way investors get around this is by purchasing shares of companies or funds that are similar to the ones they sold. For example, after you sell shares of GM at a loss, you might immediately buy shares of Ford. After 30 days or more have passed you might sell the shares of Ford and repurchase your GM shares—hopefully near the sale price you sold them for a month ago. Keep in mind that if you sell the Ford shares at a profit you’ll be generating short-term capital gains that you may need to use some of your original capital losses to offset.
Note that tax-loss harvesting only works with assets held in taxable accounts. It can't be used with tax-deferred or tax-free retirement accounts such as IRAs and 529 plans. And while potentially beneficial, tax-loss harvesting carries certain risks, particularly in volatile markets. it's also important to determine where and if this strategy aligns with your overall investment and financial goals...or if other strategies may help you achieve these same objectives with less risk. Working with an experienced financial advisor can give you greater confidence in knowing that you're making decisions that will benefit you during the current market and when it eventually recovers.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
This article was authored by Dan Flanagan and Jeffrey Briskin. Dan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or firstname.lastname@example.org. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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