What Is Tax-Loss Harvesting?
A listener asks a question about year end tax planning. Can tax-loss harvesting help your tax situation? Today we look at this strategy and how it works.
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3 What is Tax-Loss Harvesting?
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Today we answer a question from Joanne. She writes, “Last week I heard about something called tax-loss harvesting. What is it, and how can we benefit from it?” This is a strategy you can use to reduce your tax liability.
Understanding Capital Losses
From time to time, investments will decrease in value. And they may decrease to a level that is below your cost basis. Your cost basis is what you paid for the investment, plus any dividends reinvested into that position.
If the market value drops below your cost basis, you have an unrealized capital loss. You realize that loss when you sell it, and that can help reduce your income tax liability.
How Capital Losses Affect Your Taxes
First, losses offset any capital gains. Capital gains happen in two ways. They happen when you sell something for a profit. If you own a mutual fund, the fund may pay a capital gain distribution. The fund creates gains when the fund buys and sells securities.
An investor sells shares of Amazon for a $10,000 profit. They also sell shares of Ford for an $8,000 loss. They would only pay capital gains taxes on $2,000.
If your losses exceed your gains, you can use those losses to reduce other income, up to certain limits. You can use $3,000 of capital losses to reduce your other income each year. Any excess gets carried forward to future years.
Our investor sold shares of Amazon for a $10,000 gain. They also sold shares of General Electric for a $15,000 loss. You would not incur any capital gains taxes this year. They can use $3,000 of the remaining loss against their other income. The investor would have to carry $2,000 forward to use against their taxes next year.
This does not apply to any investments in an IRA, 401k, or other types of qualified plans. You are not paying capital gains taxes on anything you buy and sell in those accounts.
If you are harvesting a capital loss, you can’t buy the same investment you sold for a loss within 30 days. Doing so creates a wash sale. The IRA will not allow the loss on your taxes. If the stock you sold has a sudden increase in price, you can miss out on the gains.
Keep Good Records
If you have a large capital loss, it could take a long time to carry it forward. You will need to keep very good records.
There is Still Time for 2020
You still have time to harvest capital losses for this year. Any sales made between now and December 31 count on this year’s taxes. But you should speak to your tax professional to see what kind of impact those will have on your situation.
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About the Author
Neal Watson is a Certified Financial Planner™ Professional and a Financial Advisor with Fleming Watson Financial Advisors. He specializes in helping hard working, middle class families plan for retirement.