As the end of the year rolls around, you’re probably trying to figure out how to pay less taxes. While tax loss harvesting may not make sense in every situation, it could potentially save you hundreds of dollars in taxes. For most investors, taking the time to sell investments at a loss before year’s end might be the single easiest step to reduce tax exposure.
Here’s what you need to know about this tax-saving technique:
Top tax rates are rising in 2013
Each year, you pay tax on the realized capital gains on your taxable investments. How those gains are taxed is based on your tax rate, which can range anywhere from zero to 43.4% (for top rate taxpayers in 2013). And this is just federal! Add in the state’s take, and you can quickly see why managing this is a pretty big deal.
You need to have investments that have lost money
Interested in tax-loss harvesting? First, look at your taxable investment accounts. If you have money in a 401(k) or other tax advantaged accounts, then tax loss harvesting won’t matter — as there are no taxes to offset in tax-free accounts. Leave those alone, but within your taxable accounts, look for investments that have lost money. If you have some, you might want to consider selling to realize a tax loss.
Avoid buying the same stock you sell back
You need to be careful here, because you can’t just sell the investment and buy it back right away. If you still like the investment you’re selling, you can’t buy it back for 30 days (or the IRS will count it as a “wash sale”).
In fact, you can’t claim the tax loss if you purchased any substantially identical investment 30 days before or after the sale. If you’re worried about missing out on a possible rally during that 30 day period, you can move the money into another investment as long as that other one isn’t “substantially identical.”
You can only offset your taxable gains + $3,000
There’s no point going crazy with tax loss selling either. The goal is to offset no more than your total taxable gains for the year, plus $3,000, though additional losses can be carried over to future years. If you don’t have enough losses to offset your gains, that’s fine, but whatever losses you can realize will still offset your taxes.
Consult your tax professional
As with all tax issues, there’s no free lunch. Technically, you’re not eliminating taxes — just changing their timing — but many experts believe that achieving lower taxes sooner can be a good idea. However, if you know your tax rate is going to be materially higher in future years, you may not want to tax harvest this year.
If you’re worried your investment on which you have a tax loss will do very well over the next 30 days, and you can’t find a suitable alternative that’s not “substantially identical,” then you may not want to tax harvest.
In future years, it’s worth not just focusing on December as the month for tax loss selling, but looking for losses to harvest in your portfolio throughout the year. Tax planning should be a year round activity.
In conclusion: you have an opportunity to save money on your taxes by selling investments at a loss in your taxable accounts before December 31st. You must make sure you wait at least 31 days before buying them back, and if you end up having more than $3,000 in net losses, your loss can be applied to future tax years.
This article is a guest post from experts at FutureAdvisor, FutureAdvisor offers web-based low-cost, automated investing for those with under $500,000 to invest. You can get started for free, but automatic tax loss harvesting is a premium service.
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I just did my 2013 1040 income tax projection. My top dollars are being taxed at a 55% rate Fed and State. The real Federal rate is higher than 43.4% because itemized deductions get phased out when income exceeds $300k.
Great chart. I wish more people would take advantage of tax loss harvesting. Too many times we get emotional and want to hold our losers until they come back. By selling some of the losers, we can get a potential tax break which means saving some money.
Absolutely. For those with passive index funds, it is usually possible to find a suitable alternative as a placeholder to avoid triggering the wash sale rule and by sharing the losses but keeping the gains, you can get a much better overall return.