Tax loss harvesting (TLH) allows you to deduct up to $3,000 from investment losses against your income. This strategy can save you over $1,000+ in taxes per year ($3,000 * 37% = $1,110). It occurs when you have a capital loss in your investment account, so you sell that stock to realize the loss and reinvest the dollars in a different holding. What's great about TLH is that you get to deduct an asset typically taxed at a capital gain against your higher income tax bracket. Below we'll discuss some nuances to be aware of when pursuing this strategy such as wash sales and large capital gain avoidance.
Tax Loss Harvesting Example
Jon owns $100,000 of a long-term bond fund now worth $70,000 due to rising interest rates. He has the option to sell this fund and realize his $30,000 loss in 2024 and reinvest these dollars in a similar but slightly different bond fund to avoid the wash sale rule. If he does this, he will have a $30,000 loss that will be carried forward over the next ten years, as he can only realize $3,000 in deductions from this loss per year. However, if Jon also has capital gains then the capital losses will be deducted against the gains before deducting off of his earned income.
What Is a Wash Sale
A wash sale is when you purchase a substantially similar asset 30 days before or after you trade a security at a loss. The penalty for being caught in a wash sale is that your loss will be dissallowed and the old cost basis and holding period is added to your new asset.
Tax Loss Harvesting Total Savings
In the example above, assuming Jon is in the 37% tax bracket, he will save $1,110 in taxes per year for the next ten years if he realizes the loss. Giving him a total tax credit of $11,100! However, now he has a lower basis within his new investment that may rise in price if interest rates fall. If the bond fund value increases to $150,000 over the next 11 years he now has an $80,000 long-term capital gain that he can either realize and pay 20% capital gains tax on. Or if he was charitably inclined he could donate the shares to charity and re-purchase the asset with cash in his bank account that would have gone to the charity anyway. This allows him to completely avoid capital gains taxes and still receive the benefits of tax loss harvesting.
Tax Loss Harvesting and Charitable Giving
If Jon decides to go the charitable route then he would get to deduct the entire $150,000 off of his taxes (depending on his income) giving him the tax deduction on top of allowing him to avoid the 20% capital gains tax by passing this on to the charity that pays 0% in capital gains tax! Saving him an extra $16,000 ($80,000 (gain) * 20% = $16,000).
Simplifying Tax Loss Harvesting
Although you could tax loss harvest every year whenever there was a down market. It is easier to bank your losses when they are available in large down markets. Depending on the size of your portfolio, you may be able to sell a couple etf's or mutual funds for a $30,000 loss in order to tax loss harvest over the next ten years. However, if you realize capital gains during the ten year time period it will impact your tax loss harvesting strategy. Which is why it's important for you and your financial advisor to keep track of your overall losses/gains for the current year as well as previous years. There should be a history of losses carried forward on your previous years tax return.
Closing
Tax loss harvesting is a useful tool that can save money and should be conisdered in down markets. And don't forget the added benefit of deducting taxes at your income tax bracket and paying them at a capital gains bracket is a good strategy. If you’d like to discuss your personal tax loss harvesting opportunities and how to initiate the strategy then feel free to give me a call.
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