What is Tax Loss Harvesting?
Investing is a game of winners and losers. Some investments will perform better than you expected, while others will underperform. Tax loss harvesting is about leveraging your losses to reduce your tax burden for other investments or income. It’s about turning bad investments into something beneficial, so it’s not a total loss. Continue reading if you want to learn more about how tax loss harvesting can save you money in 2023:
When you sell a security for a profit, whether it’s a stock, bond, or mutual fund, you are taxed on your earnings. If you’ve held the security for less than a year, it’s called a short-term capital gain. And if you’ve held the security for more than a year, it’s a long-term capital gain. These two types of capital gains are taxed at different rates. Because long-term capital gains are usually taxed at a lower rate, it’s preferred to hold a security for over a year when the conditions are favorable. Here is a summary of the current rates for 2023:
Long-Term Capital Gains Tax Rate for 2023
The following rates are based on your taxable income:
|Capital Gains Tax Rate||Taxable Income (Single)||Taxable Income (Married Filing Separate)||Taxable Income (Head of Household)||Taxable Income (Married Filing Jointly)|
|0%||Up to $44,625||Up to $44,625||Up to $59,750||Up to $89,250|
|15%||$44,626 to $492,300||$44,626 to $276,900||$59,751 to $523,050||$89,251 to $553,850|
|20%||Over $492,300||Over $276,900||Over $523,050||Over $553,850|
Short-Term Capital Gains Tax Rate for 2023
Your short-term capital gains tax rate is the same as your normal tax rate – in short, your tax bracket. This ranges between 10-37%.
How to Leverage Tax Loss Harvesting to Reduce Capital Gains Tax
You can use tax loss harvesting to reduce your capital gains tax burden. When considering selling a profitable security, you can strategically sell underperforming securities to offset the capital gains incurred.
Let’s look at a few examples so you can better understand how this works:
Portfolio #1 – Industrial and Healthcare
You hold an industrial stock that is up $2,000. You also hold a healthcare stock where you are down $3,000. When filing your taxes for the year, you will owe no capital gains tax on the industrial stock earnings because your losses were more than your gains. Because you didn’t get to deduct the entire $3,000, you will also get to roll over $1,000 in losses to the next year.
Portfolio #2 – Tech and Utilities
You hold two tech stocks that are up a total of $20,000. You also hold a utility stock that is down $5,000. You will be able to offset your capital gain of $20,000 with $3,000 in losses, meaning you will only pay capital gains tax on $17,000. The remaining $2,000 can be rolled over to the next year or applied to your income tax liability for the current year.
If these are short-term gains, and you are in the 12% tax bracket for 2023, you will have reduced your tax burden from $2,400 to $2,040 by using tax loss harvesting. That’s a savings of $360. If you are in a higher tax bracket, the potential savings are even bigger.
How to Reduce Income Tax Liability
Tax loss harvesting is useful for more than just capital gains taxes, it can also be used to reduce your income tax liability. So even if you don’t sell any securities for a profit, you can still reap benefits for your overall tax burden. Let’s consider another hypothetical to demonstrate how this works:
You make $65,000 a year. As a single filer, you are in the 22% tax bracket, but your effective tax rate is about 11%. You are projected to owe roughly $7,000 in federal taxes. You have owned a poorly performing stock for six months and decide to sell at a loss of $4,000. You can use $3,000 of that loss towards your income tax liability. This reduces your tax liability from $7,000 to $4,000.
Reducing income tax liability is a great way to save on taxes, allowing you to put more money in savings or re-invest the saved money to recoup some of your losses.
Important Considerations When Using Tax Loss Harvesting
As with anything tax related, there are lots of rules and regulations you want to be aware of. We’ve compiled a list of some important considerations when taking advantage of tax loss harvesting. This list will help you better understand what you can and can’t do and how your tax burden will be impacted:
- $3,000 Yearly Limit – The IRS imposes a limit, $3,000, to the capital gain losses you can deduct on your taxes for a single year. However, if your losses exceed $3,000, the amount over the limit will roll over into the next tax year.
- No Rollover Expiration – You can roll over your capital gain losses for as many years as needed. It never expires. This means you can accumulate a large ‘bank’ of capital gains losses that are there when you want to harvest to offset capital gains.
- Does Not Apply to Tax-Deferred Accounts – You can’t use tax loss harvesting with losses from retirement accounts like 401(k)s or IRAs.
- Long to Long – Long-term losses are applied to long-term gains first. The same goes for short-term losses. Only then can any excess losses can be applied across types.
- Wash-Sale Rule – You can’t recoup the losses on a capital loss for a security that you sell if you buy a ‘substantially identical’ security within 30 days. In other words, the IRS views similar securities as having the same effect on your portfolio’s composition and performance. This applies to ANY account an investor owns, including tax-deferred accounts. To avoid this rule, wait 30 days before or after (60 days) a sale before buying a similar security.
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