Tax loss harvesting (TLH) is a term used in the financial industry to describe strategies employed by investors to minimize their taxes due on any realized gains of investment sales for the year. Realized gains occur when you sell an investment at a higher price than when you bought it.
Before reading any further, please note that TLH only applies to investments in taxable accounts, not retirement accounts or any other tax-deferred accounts. That said, let’s take a look at what this harvesting is all about.
I think an example is the best way to understand how this strategy works:
Suppose you sold shares of XYZ earlier this year for a $10,000 profit, also known as a realized gain. Let’s say that you also have a stinker, ABC, in your account that is down $15,000 from when you bought it. You can sell ABC and now have a realized loss of $15,000. This will offset the $10,000 realized gain. It will also offset up to $5,000 of any other realized gains that you have this year. If you don’t have any other gains, you can apply $3,000 to reduce your taxable income and the remaining $2,000 of losses can be carried forward to next year.
In this example, you were able to avoid paying taxes on that gain of $10,000 by using the TLH strategy.
Most investors prefer to do this strategy towards the end of the year, but you can do it any time during the calendar year. I like to do it for my clients during the slow summer months because that is one less thing to worry about during crunch time in December.
I also want to share with you some do’s and don’ts when you are considering TLH:
- Don’t sell losers just to offset gains. Make sure that the investment no longer fits with your investment objectives.
- Considering #1 above, do maximize your tax savings by using TLH when you have short term capital gains, since they are taxed at your ordinary income tax rate, which may be much higher than the long-term capital gain tax rate.
- Do sell losers if they no longer fit your strategy, even if you don’t have any gains to offset. You can always carry the losses forward to use in later years.
- Don’t buy the same investment within 30 days before or after the TLH sale. If you do, this will disallow the loss.
- Don’t ever consider any tax strategy, such as TLH, as the sole reason to buy or sell any investment. They should be incorporated into your investment decisions as part of your overall game plan.
Please comment or send an email if you have any questions.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com
