If you’ve ever asked yourself, “what if there’s a way to reduce the taxes I owe when I sell stocks or rebalance my portfolio?” then you should know about the tax-minimization strategy called tax-loss harvesting. It’s important to know exactly what it is and how it works before engaging in it. Here are the key factors that may determine if tax-loss harvesting may be right for you.
Tax-loss harvesting is a strategy used by investors to reduce their tax liability by offsetting capital gains with capital losses. The idea is to sell losing investments at a loss to offset the taxes owed on any capital gains from winning investments. This can be done by selling individual stocks, mutual funds, or exchange-traded funds (ETFs) that have decreased in value, and then using the capital loss to offset any capital gains from other investments.
For example, if an investor has a $10,000 capital gain from selling a winning stock, and a $5,000 capital loss from selling a losing stock, the net capital gain for tax purposes would be $5,000 ($10,000 gain - $5,000 loss). This means that the investor would only be taxed on the $5,000 net gain, rather than the full $10,000 gain.
One of the key benefits of tax-loss harvesting is that it can help to lower the overall tax bill for investors, not just balance out gains and losses. If an investor has more capital losses than gains, they can use up to $3,000 of excess losses to offset ordinary income each year.
However, tax-loss harvesting is not for all investors. It is generally more beneficial for an investor who has a significant amount of capital gains, is an active or accredited investor, and is in a high tax bracket.
The strategy can also have some drawbacks: If the investor is too focused on the tax advantage, they may sell winning investments and miss out on further gains and can limit an investor’s ability to make decisions based solely on their investment strategy and not on tax considerations, affecting the overall performance of the portfolio. And most of all, it can take a lot of time to diligently execute and can be a complex process.
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[1] https://www.investopedia.com/articles/taxes/08/tax-loss-harvesting.asp