The stock market throughout its history has proven to be a successful way of making money for millions of people. It is easy to understand the appeal for this fact alone. Showing its value economically, allowing ordinary people to own a piece of a major company. Like with every investment there are pros and cons aside from the risk of loss. The way we deal with these risks is by educating ourselves, learning the process of investing. One of most used tools in investing today is Tax Harvesting.
What does tax harvesting mean?
Tax Harvesting is the process of using an expected loss to lower our yearly taxes. In practical terms, when you have a basket of 20 securities, some will end up going up, and some will fall in price. Tax Loss Harvesting entails selling your losing positions to lock in the loss for tax purposes and keeps the winners unrealized. It uses the proceeds to reinvest in other similar securities.
Why do people use tax loss harvesting?
By harvesting your losses, you can claim a tax deduction by the end of the year. This strategy works very well in taxable accounts and gives us a unique advantage to others in all areas of business since there are so many business platforms where you will experience loss but have no way to balance or prepare for it. Tax Harvesting gives us three primary benefits.
a. Tax losses represent an interest-free loan which defers capital gains taxes which we would otherwise owe yearly when filing our taxes. In certain cases, we can even eliminate capital gains when we pass away.
b. Once we offset realized gains, we can then use all remaining tax losses to deduct a few thousand dollars from our standard income taxes every year.
c. Finally, any remaining losses are then rolled over into the subsequent years so that each year until your losses are used up; you can defer your capital gains and apply a significant portion of this against your income.
How can I use tax harvesting?
Let’s say you had previously invested $20,000 into an exchange-traded fund (ETF) in a taxable account, but after a steep decline, your holdings are now only worth half that. You also wish to continue to hold that fund as you are inclined to take the losses and wait for the funds to recover. With the process of Tax Harvesting, you can sell the fund and then buy it back after a period of thirty-one days. Now, you can either hold the funds in a money market fund or reinvest it into a similar fund. This allows you to keep the capital loss while allowing you to return to your original position just thirty-one days later.
A capital loss is valuable in many different ways. Before paying your capital gains taxes every year, you use your capital losses to offset the capital gains, paying only the taxes associated if you have more gains than a loss. If you are in a position where you have more loss than gains, you can apply the remaining of your capital losses against your regular income.
Don’t misinterpret this as Tax Loss Harvesting eliminating the capital gains taxes you would have paid. What this does is defers those taxes into the future. Using Tax Loss Harvesting is more equivalent to receiving an interest-free loan from the government as we can delay what needs to be ultimately paid. Also, something to remember is the additional capital gains you owe in the future will be at the lower capital gains rate while the benefits received now of the ETF deduction as your higher marginal tax rate.
Another Tax Harvesting Example
You invest a lump sum of twenty thousand in January in the Total stock market, and the balance then drops in February to fifteen thousand, and you sell it. Then in March you, you put the fifteen back into the stock market. For the following year’s tax return, since you lost five thousand you can then reduce your ordinary income by five thousand as long as you don’t have any capital gains. If you are in the high tax bracket, you may be able to reduce your tax liability as well, which will allow you to invest those savings back into the stock market.
Now imagine ten years later your initial twenty thousand that dropped to fifteen has become thirty thousand. You sell all shares and then pay long-term capital gains.
With this example, you receive two benefits. You were able to pay less in total taxes, and the taxes you owed were paid much later. While deducting the financial loss at your current marginal tax rate, you create an additional financial capital gain to be taxed when you sell later, but only at the lower long-term rate. In effect, the IRS gives an “interest-free loan” to be paid back only when you sell the stock.
While in action these things are a bit more complicated, they are beneficial for your financial portfolio both now and in the future.
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