Tax-loss harvesting is choosing to sell some investments at a loss to reduce taxes on realized capital gains from other investments. The key to successful tax-loss harvesting is to identify investments that have lost value and then determine which to sell, while staying true to your target investment mix and diversification strategy. Following are things to consider to see if tax-loss harvesting can help you lower your tax bill.
Assess Your Capital Gains
Thoroughly review your investments to determine a rough estimate of your capital gains. If you frequently buy and sell, you most likely have both short-term and long-term gains and losses. Long-term capital gains are those on investments you’ve held longer than one year, while short-term capital gains are those held for one year or less.
Estimate Your Tax Liability
After figuring out the potential amount of your capital gains, you will want to estimate your potential taxes from realized gains based on the type of gain it is and your income.
In taxable accounts, the long-term capital gains tax rate is 15% to 20% (0% for taxpayers under certain income limits), while short-term capital gains are taxed at ordinary income tax rates (10%, 12%, 22%, 24%, 32%, 35%, or 37%). Dividend income received by individual taxpayers from a domestic or qualified foreign corporation is also taxed at the same rate as long-term capital gains.
Once you have an understanding of what you will owe in capital gains taxes, you can start looking for investments you want to sell. You may first want to consider investments that no longer fit into your strategy or those that have poor prospects for growth in the future.
To increase your potential tax savings, try to apply as much of your capital loss to short-term gains, because they are taxed at a higher rate. The tax code states that short-term and long-term losses have to first be used to offset gains of the same type. If you have losses of one type that exceeds what you have gained, you can then apply the excess to the other type of capital gains. For example, let’s say you sell a long-term investment at a $16,000 loss but only had $5,000 in long-term gains for the year. You could then apply the excess of $11,000 to any short-term gains.
Additionally, if you don’t have any gains in a given year, the tax code allows you to apply up to $3,000 in capital losses to reduce your ordinary income, which is the same rate as short-term capital gains.
Watch out for the Wash-Sale Rule
After you’ve sold the investments with losses, you will mostly likely start looking for new investments. Even though you took a loss on an investment to reduce your capital gain taxes, you may decide that it is still an attractive investment because it has good potential and still fits within your investment strategy. Be careful when you buy it because the wash-sale rule will disallow your tax write-off if you buy the same security, an option to buy the security, or a substantially identical security within 30 days before and after the date you sold the security with the loss.