How to Take Advantage of Tax Loss Harvesting in a Down Market

Volatile stock markets, as we’ve been experiencing this year, can be nerve-racking. However, they can also provide opportunities. One of those opportunities is the ability to “harvest” your losses and reduce your taxes. Keep reading to find out what tax loss harvesting is and how you can use down markets to take advantage of it.

What Is Tax Loss Harvesting?

Tax loss harvesting is a strategy investors use when they experience portfolio losses—for example, in a market drop. It’s a bit like making lemonade out of lemons since no one likes to see losses. With tax loss harvesting, you sell some of your losing investments and then use those losses to offset the gains you make from selling other investments.

For example, say you have a long-standing stock that you sell for a gain of $10,000. Without the harvesting strategy, you must pay capital gains tax on that $10,000. (You would pay income taxes if you bought the stock less than a year ago.)

But let’s say you sold stock that tanked in a down market and took a loss of $6,000. You can offset the $10,000 gain with the $6,000 loss. That means you would pay taxes on only a $4,000 “gain.”

So down markets can present a silver lining. Talk to a financial advisor about whether tax loss harvesting could be a silver lining for you, given your financial situation and goals.

What Else You Need to Know About Tax Loss Harvesting

You aren’t limited to using your investment losses in the same year you cash them in. You can “carry over” those losses to future years indefinitely—there is no sunset date for using them. That means you can continue to offset your gains until you’ve used up your losses.

You can also use your carryover losses to offset up to $3,000 in ordinary income. Our fiduciary financial planning firm in Greenwood Village, CO, often works with clients to use the tax loss harvesting strategy to offset higher-income tax years.

It’s important to note that you can use this strategy with taxable accounts only, such as a brokerage account. Since your IRA or 401(k) is taxed only when you make withdrawals, your gains and losses beforehand aren’t considered.

You also need to be aware of the “wash sale rule,” which means you cannot sell a security at a loss and buy a “substantially identical” stock within 30 days. Read this Investopedia article for more information on the wash sale rule, or talk to a financial advisor or tax professional to make sure you avoid trouble with the IRS.

Finally, the strategy requires proper matching of stock and tax types. For instance, you will need to match your short-term losses with your short-term gains since anything held less than a year would be taxed as ordinary income. The same applies to securities that would incur capital gains taxes because you’ve had them for over a year.

Final Thoughts

Tax loss harvesting can prove to be the upside to a down market. Since the tax rules can get complicated, we advise working with a financial advisor to make sure you have dotted your i’s and crossed your t’s. That said, the strategy can be an effective way to reduce your taxable income in the year you take the losses and in years to come.

We offer a complimentary 15-minute call to discuss your financial situation and concerns and share how we may be able to help.

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