In tough economic times, it can be difficult to focus on the upside. Long-term investors, however, should tap into their inner optimism through a big opportunity: reaping tax losses. What is tax-loss harvesting and why is now the perfect time for it? Keep reading to learn more.
What is tax-loss harvesting?
In his heart, tax-loss harvest is a strategy that turns stock loss into taxable losses. The strategy is simple: sell underperforming stocks and see a loss on your taxes. These taxable losses can then offset other portfolio gains, potentially eliminating their tax effect altogether.
It works like this: imagine you have XYZ stock trading at a loss of $1,000 in a taxable market. brokerage account. You have capital gains of $3,000 for the year. By selling XYZ stock, you realize a loss of $1,000, which reduces your capital gains for the year to $2,000. By simply selling a losing stock, you have reduced your taxable gain by one-third.
When it comes to tax loss harvesting, understand which of your holdings are short-term and which are long-term. Investments are considered long-term if held for more than a year and a day and are taxed at lower rates. When harvesting losses, short-term losses offset short-term gains and long-term losses offset long-term gains. If you have gains in one category and losses in the other, the results are offset against each other. Any loss can then offset other types of taxable income.
Know This First
While tax loss harvesting is a valuable tool during bear markets, there are two concepts you need to understand before putting it into practice. Wash sale rules dictate how you can reinvest the proceeds of a sale, and loss carryforwards can affect your taxes for years to come.
Under the washing rule, investors who redeem identical shares within thirty days before or after the sale of the shares are not allowed to recognize a taxable loss. For those hoping to take advantage of bear markets with a tax-loss crop, a wash sale can ruin your strategy. There are two ways to avoid the wash sale rule. First, do not buy back the same shares within thirty days of the sale. Second, buy similar but not identical investments. For example, selling the Fidelity Total International Index Fund and buying the Vanguard Total World Stock Index Fund, even if their holdings are similar, would not prevent you from recognizing a loss under the wash sale rule.
But what if your entire portfolio is down for the year and you don’t have a taxable gain to offset the loss? Fortunately, the tax code allows taxpayers to recognize a loss in the given year and carry forward their losses to future years. You can only recognize a capital loss of $3,000 in any given year, and the rest can be carried forward indefinitely.
Why it’s a good time to harvest
You don’t need to ask an economist to know that the economy is facing serious headwinds. The combined forces of galloping inflation and the economic downturn have many fearing stagflation. At the end of last week, it was announced that the US GDP was facing an economic contraction for the second consecutive quarter, putting us definitively in recession. So what does this mean for your wallet?
If you’re like many Americans, your investment portfolio isn’t in the best shape right now. But all is not gloomy. It may be a good idea to employ a tax loss harvesting strategy, especially if you recognized gains earlier in the year. Through tax loss harvesting, you can make the most of bear markets this year and for years to come.
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