Once a year, investors get a chance to lower their tax bill on investments outside of tax-advantaged 401(k) and IRA accounts. It can save thousands annually and is not difficult to do, but it requires the discipline to take the time to gather your records and remember the rules. We're here to help with tax-sensitive investing, and what follows is a reminder about how tax-loss harvesting works.
This maneuver enables you to lower your taxes by realizing investment losses and applying against capital gains or ordinary income. Even though you might not have any gains right now, you can use loss-harvesting in the future for gains or income. Here's how it works:
Sell an investment valued at less than you paid for it.
Use that loss to lower capital gains on a profitable investment or deduct up to $3,000 of losses from your income.
Reinvest in investments that fit into your portfolio and match your strategic goals.
The steps in tax-loss harvesting are:
Picking What to Sell. Review your portfolio and identify what no longer fits. Did that hot stock tip from your brother-in-law not work out? Sell it and use the loss to offset the gain reaped by selling a winning investment.
Favor Short-Term Gains and Losses. Securities bought and sold for a year or less are subject to ordinary income tax rates, which can range as high as 37%, depending on your bracket. But long-term gains (investments held for more than a year) are taxed as capital gains and at a lower rate: 15% for most people and 20% for high-income joint-filers — $425,801 or more for singles, $479,001 or more for couples. IRS rules require you first apply all your short-term losses to offset short-term gains, but any additional short-term can offset long-term gains realized in 2018.
Watch Out for the Wash Sale Rule. This IRS dictum forbids you from taking a tax write-off if you buy the same security, or one "substantially identical," as you sold within 30 days before or after the transaction. One way around that is to substitute a mutual fund or ETF that tracks the industry your stock is in.
Be Aware of Cost Basis. When evaluating what to sell, knowing the cost basis of taxable security is critical. Cost-basis is the price you paid for a security, plus brokerage costs or commissions. If you bought XYZ for a $10 share and sell it for $25, your gain is $15. Monthly and annual brokerage statements show the cost basis.
Choose Your Method. One final complication: You must choose one of two methods for accounting for your security. The "average-cost" method is easiest if you added to a position over time. Then, you cost-basis is determined by averaging the cost per-share of all your purchases. The other method uses the actual cost of each lot of shares purchased, and lets you pick specific, higher-cost lots to sell, which can boost the amount of the loss and can most efficient.
With the longest bull market for stocks in post-War America continuing in 2018, and volatility higher — and outsized gains in large technology stocks — opportunities to harvest losses may be more common than usual this year. This is a reminder of what can be a highly technical and important subject best handled with guidance from a tax and financial planning professional. We are here to answer any questions and help you implement tax-efficient investing strategies.
This article was written by a professional financial journalist for Forbes Financial Planning, Inc and is not intended as legal or investment advice.