Maximizing Returns with Tax Loss Harvesting
Want to learn how you can optimize your stock portfolio while minimizing tax liabilities? Tax loss harvesting can be a strategy you can use to do that!
What Is Tax Loss Harvesting?
Tax loss harvesting is a strategy that allows investors to offset their taxable gains by selling investments that are current losses. By strategically selling investments that have declined in value, you can offset capital gains tax, which will reduce your overall tax burden on other investment returns. This strategy is 100% legal and used often by more advanced investors, but anyone can use it!
Benefits of Tax Loss Harvesting
Tax Reduction
By strategically harvesting losses, investors can reduce their tax liabilities on capital gains. The losses can be used to offset gains in the same year or carried forward to offset gains in future years.
Portfolio Optimization
Tax loss harvesting offers an opportunity to rebalance and optimize investment portfolios. Selling investments that have experienced losses allows investors to reallocate their capital to more promising opportunities or adjust their asset allocation based on changing market conditions.
Potential for Increased Return
By reducing tax obligations, investors can keep more of their investment returns, potentially leading to higher overall portfolio growth.
Considerations To Follow
While tax loss harvesting can be a valuable strategy, it is essential to keep the following considerations in mind:
Wash-Sale Rule
Investors must avoid repurchasing the same or substantially identical security within 30 days before or after the sale to claim the loss for tax purposes.
Long-Term Capital Gains
If an investor has no short-term capital gains to offset, they can use harvested losses to offset long-term capital gains, which are generally taxed at lower rates.
Tax Bracket, Loss Limits, and Carryover
Depending on an investor’s tax bracket and the magnitude of capital losses, the benefits of tax loss harvesting may vary.
Up to $3,000 in net losses can be used to offset your ordinary income, which includes income from dividends and interest.
Unused losses can be carried forward to future years, providing potential tax benefits down the line.
Consult a Tax Professional
Tax rules can be complex, and individual circumstances may vary. It is always advised to consult with a qualified tax professional to determine the best approach for your specific situation.
Examples Of Tax Loss Harvesting
Selling stocks in one company to buy another
If you have stocks that have continued to lose you money and you wish you could get rid of them, it may be an opportunity to optimize your portfolio. You can sell the stock and realize the loss to purchase another stock that you think will perform better in the long-run. Remember that you can only offset your ordinary income by up to $3,000 a year.
Selling stocks to offset realized gains
Let’s say you decided to sell your Nvidia stocks after a massive rally because you’re happy with the gains and don’t think the stock will stay elevated at its current price. Once you sell for a profit, you have realized gains, which are taxable. You can minimize your capital gains tax by selling stocks that you’ve lost money on that you planned to sell eventually to offset your tax liability.
Using ETFs for Tax Loss Harvesting
Exchange-Traded Funds (ETFs) provide an excellent vehicle for tax loss harvesting due to their structure and diversification benefits. If you want to learn the basics of building a diversified portfolio, read this post.
Here’s how ETFs can be utilized in this strategy:
Broad Market Exposure
ETFs often track broad market indexes, such as the S&P 500 or total bond market indexes. Selling an ETF that has experienced losses allows investors to capture the tax benefits while maintaining exposure to the overall market.
Similar Replacement
After selling a losing ETF, investors can purchase a similar, but not substantially identical, ETF to maintain market exposure. This avoids the “wash-sale” rule, which prohibits claiming losses if the same or substantially identical security is repurchased within 30 days.
The IRS doesn’t have a clear rule on what is considered “substantially identical” and it can be challenged by the IRS at any point. To be safe, I would recommend not swapping ETFs that are similar such as a “total market” ETF for another “total market” ETF or ETFs within the same sector.
Asset Class Switch
ETFs provide investors with a wide range of asset classes and sectors. Tax loss harvesting offers an opportunity to switch between ETFs that track different sectors or asset classes, allowing for strategic portfolio adjustments. An example would be a tech-heavy ETF for a dividend ETF.
Cost Efficiency
ETFs typically have low expense ratios and are known for their tax efficiency due to the creation/redemption mechanism. This makes them an attractive choice for tax loss harvesting, as the tax implications are minimized.
Final Words
Tax loss harvesting is a powerful strategy that allows investors to optimize their investment returns while mitigating tax liabilities. ETFs, with their broad market exposure, cost efficiency, and tax advantages, make them excellent candidates for tax loss harvesting.
