What You Need to Know about Tax-Loss Harvesting

Not every investment will be a winner, but a strategy called tax-loss harvesting can potentially lower your tax bill. It involves selling investments at a loss to secure capital gains that may be taxed at more favorable rates. While tax-loss harvesting won't eliminate your taxes, it may offset what you owe on your taxable investment accounts and balance your taxes across your investment portfolio.

Understanding Capital Gains Tax

Capital gains are profits you make after selling certain assets, such as real estate, stocks, bonds, and digital assets such as NFTs and cryptocurrencies. However, you’ll owe taxes after that asset is sold. The amount you owe will depend on several factors, like what the asset is, how long you’ve owned it, and how much value it accrued over time.

There are two types of capital gains taxes:

• Short-term gains – profits you make from selling assets you've owned for a year or less. They're typically taxed at the same rate as your typical income.
• Long-term gains – gains from assets you sell after over a year of ownership. Taxation rates are often lower than with short-term gains and ordinary income.

Even if your portfolio has experienced more losses than gains, you can use the losses to lower your taxes. If you experience a net loss, realized capital losses can lower your taxable income by up to $3,000 a year. When your capital losses exceed that amount, you can carry the excess amount into the next tax season.

Impact of Taxes on Investment Returns

A balanced, diversified portfolio contains tax-advantaged, tax-free, and fully taxable investment vehicles and investment accounts. This includes stocks, bonds, money market deposit accounts, municipal bond funds, and tax-advantaged and tax-free investment accounts. The makeup of your portfolio affects your tax burden, so it’s important to understand how your investment accounts and vehicles are working for you.

The Basics of Tax-Loss Harvesting

Tax-loss harvesting can be a smart investment strategy that enables you to optimize your tax liabilities by strategically selling investments that have experienced losses. It can help you offset capital gains by realizing capital losses and reducing the overall tax liability on investment returns.

When you sell an asset for less than its purchase price, you incur a capital loss. These losses may help offset capital gains, which are profits made from selling investments for more than their purchase price. By selling investments at a loss, you may reduce your taxable income, potentially leading to a lower tax bill.

Along the way, it's essential to be mindful of the tax rules and regulations. One example is the IRS's "wash-sale" rule, which restricts selling and repurchasing the same or substantially identical securities within 30 days to claim a loss.

Issues to Consider Before Utilizing Tax-Loss Harvesting

Before implementing a tax-loss harvesting strategy, it's essential to weigh some potential issues in the balance. Tax-loss harvesting, while a valuable tool for reducing tax liabilities, can present some complexities and potential drawbacks. These may include:

1. Wash-Sale Restrictions: These rules state that if you sell a security at a loss and buy the same, or "substantially identical," security within 30 days before or after the sale, the loss is typically disallowed for current income tax purposes.
2. Short-Term vs. Long-Term Gains: When harvesting losses, it may be more beneficial to focus on short-term losses, which can offset short-term gains and are taxed at a higher rate. Long-term losses may also offset long-term gains. However, the tax savings might not be as significant since they’re taxed at a lower rate.
3. Account Limitations: Tax-loss harvesting isn’t useful for certain retirement accounts, including a 401(k) or an IRA, since you can’t deduct losses generated in a tax-deferred account.

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This material was developed and prepared by a third party for use by your Registered Representative. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The content is developed from sources believed to be providing accurate information.