Are you doing enough to manage your investment taxes? When you invest in a taxable account, you are taxed on your investment gains, so you’ll want to manage your investments in a tax-efficient way, notes Janet Brown, mutual fund expert and editor of No-Load FundX Newsletter.
To help you make tax-smart changes to your investments before the end of the year, FundX investment advisors are sharing some of what they do to help their wealth management clients reduce their tax burden.
(Editor's note: For additional guidance, read Janet Brown's review of Year-End Tax Distributions here.)
Now we’re turning our attention to tax-loss harvesting, a strategy that helps you use investment losses to offset your taxable gains.
Here are a few common FAQs to help you know more about what tax-loss harvesting entails and who should do it. Plus, five tips that can help you (or your financial advisor) make the most of this tax-smart strategy.
What is tax-loss harvesting?
Tax-loss harvesting is when you strategically realize losses during the tax year in an effort to lower your overall tax bill.
Do I need to worry about tax-loss harvesting?
Anyone with a taxable portfolio (as opposed to a tax-deferred IRA or retirement plan) should consider ways to reduce their investment taxes, but it’s probably most important for investors who are in a higher (15% or more) tax bracket.
If you’re in the 10-15% tax bracket, you aren’t taxed on your investment gains, so there’s no real reason to try to offset taxes on your gains by harvesting losses.
Why should I realize losses?
It’s a way to convert your investment losses into a tax break. Usually, you can claim up to $3,000 per year in losses even if you haven’t realized any gains to offset. And if you lose more than the $3,000 limit, you can carry over the excess amount to offset capital gains or other income on future tax returns.
When should I look to take losses in my investment account?
Whenever you see an opportunity to do so! In the accounts we manage for our wealth management clients, we look to realize losses in volatile markets, when we’re investing in a client’s account, when we’re rebalancing clients’ portfolios, and at year-end when mutual funds make distributions. In short, it’s always a good time to look for tax savings.
How do I harvest losses?
You’ll want to pay attention to the cost basis (your adjusted original purchase price) to determine which funds you own at a loss. If you bought the fund on multiple dates, you may need to identify the specific trade lots that you can sell at a loss. Then, you’ll sell the fund, realize the loss, and reinvest the proceeds in a new fund.
Remember the wash sale rule: if you sell a fund to realize a tax loss, you can’t buy a “substantially identical” fund again for at least 30 days, according to the IRS.
If you buy in sooner, you can’t use the loss to offset your gains; you’ll “wash away” the tax benefit. In our client accounts, we look for funds to buy that are similar (have a high correlation) but are not identical.
Tax-Loss Harvesting Tips
Here are some ideas for tax-efficient fund investing all year round.
1. Don’t just pay attention to taxes at year end
If you own funds in a taxable account, you probably know that year-end mutual fund distributions can help you harvest losses. However, if you mostly harvest losses at the end of the year, you may miss out on important tax-loss harvesting opportunities during the rest of the year.
2. Don’t sell a fund only for a tax break
You can get so focused on booking losses in your portfolio that you neglect the real reason you’re investing: to achieve long- term growth. You don’t have to act on every volatile move in the markets. If there’s nothing fundamentally wrong with your investment, you may be better off holding it unless you find something better.
3. Don’t forget to reinvest!
If you sell a fund to realize a loss, you should know how you’ll reinvest the proceeds and then make sure you follow through. If you stay in cash too long, you could miss out on good gains.
4. Don’t focus only on short-term gains and losses
You might assume that you can only offset short-term gains with short-term losses and long-term gains with long-term losses.
In fact, losses on your investments are first used to offset capital gains of the same type (short-term losses are first deducted against short-term gains, and long-term losses are deducted against long-term gains). But then, net losses of either duration can be deducted against the other kind of gain.
5. Carry your losses forward
People may also forget that when you have a terrible year with more losses than gains, those losses not used to offset gains this year may be used (carried forward) in future years indefinitely. This is one of the few silver linings to losing money in the stock market!
