As the year draws to a close, many people examine their financial situation. At times, the goal is to take last-minute actions that can lower your tax liability. If you have some losing investments, selling those stocks could help you reduce what you owe. With the tax-loss harvesting strategy, you can reduce what you pay in capital gains taxes. Here’s a look at how it works.
How Tax-Loss Harvesting Gives You a Tax Break
With tax-loss harvesting, you sell losing stocks to reduce the tax impact your gains. This allows you to reduce the amount you owe in capital gains taxes. The loss offsets some or all of your gains, lowering your tax liability.
If you don’t have any investment gains, you can still use the approach to lower your taxes. The losses can offset taxes owed on regular income, as well. However, the amount you can offset is limited to $3,000 annually on a tax return ($1,500 for spouses who are using the married filing separately status).
Not all investments can be used for tax-loss harvesting, though. The stocks have to be in a taxable account, like a regular brokerage account. Investments in tax-sheltered accounts like IRAs, 401(k)s, 403(b)s, and 529 college savings plans can’t be used for this strategy.
Additionally, you can only use tax-loss harvesting to lower your tax bill if you complete the sale before the end of the tax year. There isn’t a grace period like you receive for activities like funding an IRA, where you have until April 2020 for the 2019 tax year. For 2019’s taxes, that means you have to finish your tax-loss harvesting by December 31, 2019.
IRS Rules for Tax-Loss Harvesting
It’s important to understand that you won’t find the phrase “tax-loss harvesting” in any Internal Revenue Service (IRS) publication. The term describes a strategy, that’s all.
However, that doesn’t mean there aren’t rules that govern the associated activity. First, you have to deal with wash sales rules. These state that if you sell and then invest in the same stock or fund or something “substantially similar” to what you sold within 30 days of selling, your loss is disallowed. That means your tax break would effectively be reversed by the IRS, likely leaving you owing more in taxes. If you aren’t sure whether that scenario will apply to you, then it’s wise to consult with a tax professional to make sure you avoid the situation.
Additionally, you have to be careful when calculating your losses. Unless you purchased all of the losing stock at the exact same time, you probably paid different prices for it over time. You’ll need to carefully examine your records to make sure your cost basis calculations are accurate.
Further, the IRS requires that any offsets by loses be applied to the same type of gains. For example, if you sell a long-term investment, you have to apply that loss to your long-term gains first. Unless the amount exceeds your long-term gains, you can’t apply any to your short-term gains. Since short-term gains are taxed at higher rates, this can be frustrating. But, even if that’s the case, you have to follow the IRS rules.
You Might Want to Wait
While the idea of selling losing stock for a tax break might be enticing, the strategy only really pays off if you aren’t in a low tax bracket. While it may technically still work, you might experience more savings if you wait until you’re in a higher bracket.
Additionally, you don’t want to sell losing stock just for the tax break. Often, investing in stock is a long-term game. You’re aiming for growth over years or even decades. Unless there is something wrong with the investment and its long-term potential is effectively gone, or it no longer aligns with your investment strategy, you might want to consider holding on to see if it rebounds.
Finally, if you notice that a stock has turned into a loser during November and December, but was doing okay before, you might want to wait. Since many investors use tax-loss harvesting strategies at the end of the year, there could be an increase in the number of sales. This pushes the value of the stock down, but the effect may be temporary. Once tax-loss season ends, it could go back up fairly quickly in the new year.
Should You Sell Losing Stocks to Pay Less in Taxes?
Ultimately, deciding whether you want to sell your losing stocks is a personal decision. However, if you’re in a higher tax bracket, have a significant amount in capital gains, and have some losing investments that aren’t likely to recover or don’t fit in with your investment strategy any longer, it could be worth exploring. If you aren’t sure whether it’s wise, speak with a financial advisor or tax specialist. They can help you understand your options and choose a path that’s right for you.
Do you plan on selling losing stocks to pay less in taxes this year? Why or why not? Share your thoughts in the comments below.
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Tamila McDonald has worked as a Financial Advisor for the military for past 13 years. She has taught Personal Financial classes on every subject from credit, to life insurance, as well as all other aspects of financial management. Mrs. McDonald is an AFCPE Accredited Financial Counselor and has helped her clients to meet their short-term and long-term financial goals.