There are many reasons having a financial plan is valuable, but maybe the most significant is that it can help you understand how to react to the latest negative headlines.
Tax Loss Harvesting: What is it?
Who likes to pay lower taxes? Most do and one way to accomplish this is through Tax Loss Harvesting.
When you use a taxable account to invest there is the added advantage to use the losses that may occur to lower your tax bill. There are three benefits to Tax Loss Harvesting:
- Tax losses represent an interest-free loan that defers capital gains taxes you would otherwise owe into the distant future, and can even eliminate them entirely when you die.
- After offsetting realized gains, you can use any remaining tax losses to deduct up to $3,000 from your regular income taxes each year.
- Any remaining losses are rolled over into the subsequent years, so each year until your losses are used up, you can defer your capital gains and apply up to $3,000 against your income.
Suppose you had invested $10,000 into an ETF in a taxable account and later that year it fell to $7,000. Using tax loss harvesting strategy, the ETF is sold to lock in the $3,000 capital loss. Since you are a long-term investor you probably want to do one of two things:
1. Buy a similar but not the exact same investment after selling the ETF for a loss.
OR
2. Wait at least 30 days to buy the same ETF again.
If you buy the same investment within 30 days the "wash-sale" rule applies and you will lose the benefits of having a capital loss.
The capital loss is valuable in several ways. Before you pay any capital gains taxes each year, you use your capital losses to offset any capital gains, and pay taxes only if you have more gains than losses. If you have more losses than gains, you can apply up to $3,000 of your remaining capital losses against your regular income. And whatever capital losses are still left over can be carried forward indefinitely into future years. Each year, you get to first apply the carried forward losses against capital gains, and then use any remainder (up to $3,000) to reduce your ordinary income.
Using tax loss harvesting to offset capital gains doesn't actually eliminate the capital gains taxes you would have paid. Instead, it defers those taxes into the future. However, future money is worth less than money today.
Using tax loss harvesting to defer capital gains taxes is like receiving an interest-free loan from the IRS. Also, if you still own the shares when you die, your heirs will receive a stepped-up basis, and you will have gotten the up-front benefit from tax loss harvesting while avoiding the taxes on the back end entirely. Finally, the capital gains you owe in the future will be at the potentially lower capital gains rate, while the benefit you receive today of the $3,000 deduction is at your potentially marginal income tax rate. Remember, tax loss harvesting does not work in 401(k), IRA and other retirement accounts. Only taxable accounts.