How does tax loss harvesting work and why is it beneficial for you?

Art 39Efficiently managing your investment portfolio to cut down on taxes can be incredibly impactful to your overall financial future.

Are you familiar with the concept of tax-loss harvesting? This trick can really help you keep things tax-friendly in the long run, especially when the markets fluctuate.

What is tax-loss harvesting?

Tax loss harvesting is a strategy used by investors to minimize their tax liability by selling investments that have experienced a loss. By realizing these losses, investors can offset their capital gains and potentially reduce the amount of taxes they owe on their investment gains.

This technique involves selling underperforming assets to generate losses, which can then be used to offset gains and even potentially reduce your overall taxable income. It's an efficient way to balance your portfolio and make the most of market fluctuations.

How does tax loss harvesting work?

Fluctuations in the market occur on a daily basis. Various sectors get hit at different times, depending on what's happening in the world and the economy. When a stock loses value, it can be a good chance for your financial advisor to perform some tax-loss harvesting magic for you.

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Simply put, the steps a financial advisor would take in this process include:

  1. Assess your investment portfolio to identify assets that have experienced losses

  2. To maintain your desired asset allocation and market exposure, your advisor will help you identify and purchase similar investments

It’s important to note that the two steps above should happen on the same day to keep you fully invested, and your portfolio would stay engaged with a similar stock, ensuring you continue to take advantage of any upticks in that particular sector.

The IRS requires that the replacement investment should bear similarity, but not be an identical match. It's crucial for your advisor to have a grasp of the IRS Wash Sale Rules for executing tax-loss harvesting transactions. These regulations stipulate that if you sell an investment at a loss, you're prohibited from holding the exact same investment for the subsequent 30 days. Otherwise, the tax benefit of the loss will be invalidated. Nevertheless, you're permitted to repurchase the original investment once the 30-day period has passed.

Would this be beneficial for me?

An ordinary loss resulting from the sale of investments typically falls into the category of “capital losses.” These losses can be utilized to counterbalance any capital gains you've earned within the same year.

A significant benefit of capital losses is that if they surpass your capital gains in a specific year, the IRS permits you to deduct a net capital loss of up to $3,000 from your other income. Any unused portion of capital losses can be carried forward to subsequent years indefinitely, without any time limit according to current regulations. This offers a considerable advantage as you can apply these losses in future years when the stock market performance is potentially more favorable and your capital gains are higher.

This strategy not only aids in potential tax reduction but also enables you to preserve a larger portion of your portfolio's future growth by reducing future years' capital gain income. Tax loss harvesting can be especially beneficial for:

  • High-income earners. Individuals in higher tax brackets can use tax loss harvesting to offset their taxable income, resulting in significant tax savings.

  • Long-term investors. Those who plan to hold onto investments for an extended period can benefit from carrying forward unused capital losses to offset future gains, even if those gains occur in subsequent years.

  • Investors with large or diverse portfolios. Investors with diversified portfolios are more likely to have investments with losses at any given time. Tax loss harvesting allows them to use those losses strategically.

  • Anyone approaching (or already in) retirement. Individuals who are approaching retirement or are already retired can use tax loss harvesting to manage their income in a tax-efficient manner and preserve their retirement savings.

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When should tax-loss harvesting be completed?

Rather than being limited to a specific time frame, tax-loss harvesting can be completed strategically throughout the year. It's important to align the practice with the natural rhythm of market fluctuations. While many investors consider year-end for this activity, it's actually more effective when integrated into your investment management routine. By regularly reviewing your portfolio and identifying opportunities for tax-loss harvesting, you can make the most of market movements, potentially minimizing tax liability and optimizing your overall investment strategy.

Get help from a financial advisor

Being tax-savvy with your investments includes keeping an eye on market dips throughout the year, allowing you to capitalize on potential tax-saving opportunities through strategic tax-loss harvesting.

We know it can be hard to keep up with the market’s fluctuations, which is why a financial advisor who understands how tax loss harvesting works can help lower your taxes big time and allow greater growth retention within your investment portfolio!

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Savant Wealth Management
Written bySavant Wealth ManagementContributing writer

Savant Wealth Management, an esteemed financial advisory firm, has been a steadfast pillar of wise counsel in the realm of wealth management since its establishment in 1986.