Most people I know really don’t like to lose money with their investing. That just makes sense. But what if I told you there was a way to cash in on those losses? Would that change your mind about that red ink? What if I went one step further and said that it might be in your interests to sell a fund for less than you paid for it? Would you think that I’d lost my mind and that such thing is impossible?
Well, if you thought that way you might miss out on some very sweet tax giveaways Uncle Sam is just dying to send your way. What I’m referring to is “tax loss harvesting” and how it can put lots of dollars in your pockets around tax time.
What Is Tax Loss Harvesting?
Tax loss harvesting is the process that sharp investors engage in towards the end of the year. They look for funds (or stocks) that currently trade below the price they paid for them. Then, they sell the position and lock in the realized loss. At that point, they have three choices;
1. Do nothing.
2. Buy the stock or fund back in 31 days to avoid the wash sale rule. This allows them to nail down the tax loss yet still own the position. Of course the risk is there. If the stock moves up dramatically during that 31 days, the investor that sat on the side lines is out of luck.
3. Buy a similar stock or fund the day they sell the original fund to lock in the tax loss. This gives them the tax loss and it eliminates the market risk of being out of the market. The only downside here is that the original stock could go up more than the replacement position.
What Is The Benefit Of Harvesting Tax Losses?
You can use the investment losses that you harvest to offset gains you realized with other transactions. For example, let’s say you invested $10,000 in XYZ and sold it for $12,000. That’s nice – but it leaves you with a $2,000 taxable gain. If you scout your holdings and sell something else that generates a $2,000 loss, you won’t have any taxes to pay on the gain. Remember, if you sell the loser, you can buy something else just like it so you won’t be out of the market. Life is sweet. Stop and smell the dollars.
And if you still have losses on your books after you’ve wiped out the realized gains from other investment activity, you can use $3,000 of the write off to offset taxable income. Pinch me.
Why Is Now A Great Time To Harvest Investment Losses?
The market has been really volatile this year. And that roller coaster ride may not be over. If you are sitting on a big loss in a position, consider selling it, locking in the loss, and using one of the three strategies I outlined above.
Just don’t wait around for the market to implode before looking into this. Identify tax loss candidates now (and their replacements). This way, if the market takes a big dive, you can implement this strategy, snag a nice tax benefit and buy new shares of a different but similar position (if you select option 3) at a discount.
Investing involves risks. And investors do lose money sooner or later. But just because you lose money on a transaction doesn’t mean you have to take all the loss on your shoulders alone. If you play your cards right and use tax loss harvesting, you can make the IRS your partner by sharing some of those losses with them.
Are you harvesting losses to reduce your tax liability for next year? What other end-of-year tax strategies are you going to use?