Part 1: What is Tax Loss Harvesting, How it Works, A Detailed Example, Wash Sale Rule
Part 2: Pros and Cons of Tax Loss Harvesting, Should You Use It
Introduction to Tax Loss Harvesting for Kids and Teens
This video explains the concept of tax loss harvesting in a simple, concise way for kids and beginners. It could be used by kids & teens to learn how to harvest tax loss, or used as a money & personal finance resource by parents and teachers as part of a Financial Literacy course or K-12 curriculum.
Suitable for students from grade levels:
- Middle School
- High School
The topics covered are:
- What is tax loss harvesting
- How does tax loss harvesting work
- A detailed example
- Can you offset any gain against any loss
- Can you repurchase the investment I sold immediately (wash sale rule)
- What are the advantages of tax loss harvesting
- What are the disadvantages of tax loss harvesting
- Should you use tax loss harvesting
What is tax loss harvesting?
Tax loss harvesting is a strategy where you sell some securities at a loss to offset some or all of the gains you may have realized in other investments, thereby reducing your capital gains tax.
When you sell investments for more than you bought them for, that’s a capital gain and will be taxed. This is true for real estate, stocks, mutual funds, ETFs, or any other asset.
Tax loss harvesting is a tried and true strategy that helps reduce your overall tax liability and increase your after-tax returns.
How does tax loss harvesting work?
If you are looking to reduce your tax liability, you can look for investments that are not performing as expected.
You sell those investments at a loss and use the losses to offset capital gains you made that year and also potentially reduce your ordinary income by up to $3,000. Any unused losses can also be carried forward indefinitely if they exceed the annual limit.
You replace the securities you sold by purchasing different securities that are aligned to your investment needs. This is what distinguishes tax loss harvesting from simply trying to time the market.
Remember, this strategy only applies to investments in taxable accounts since the whole idea is to lower your tax burden.
Also, you need to complete the harvesting before Dec 31 – there is no grace period.
Can you give me an example?
If you had a $5,000 profit from selling stock A, you’d need to pay taxes on that.
But if you also sold stock B for a $3,000 loss, you could use this to offset your gain and only be taxed on the difference of $2,000.
On the other hand, if your losses were $10,000, in addition to offsetting your $5,000 gain entirely, you can also deduct up to $3,000 from your regular income that year, and carry forward the remaining $2,000 loss to future tax years.
Can I offset any gain against any loss?
Generally, short term losses (assets sold within 12 months of purchase) are used to offset short term gains and long term losses (assets held for more than 12 months) are used to offset long term gains.
But if the losses are more than the gains in that category, you can apply them to other gains as well.
Don’t sell your investment just to avoid paying taxes. Long term investing is the best strategy – so even if some of your portfolio is underperforming, you might benefit from holding on and letting the market correct itself over time.
Having said that, there could be some fundamentally bad investments that you want to get out of and that’s what tax loss harvesting should be used for.
Can I repurchase the investment I sold immediately?
No, the wash sale rule prevents tax loss harvesting investors from buying the same or a ‘substantially identical’ security less than 30 days before or after the sale.
To avoid violating this rule, investors often wait at least 31 days before repurchasing the same security.
You could also replace the sold security with a different one that is similar but not ‘substantially identical’, although this may be tricky and require a financial advisor.
What are the advantages of tax loss harvesting?
The biggest advantage of tax loss harvesting is it helps reduce your tax liability and boost your post tax returns.
If an investor is in a high tax bracket and is offsetting gains from short term capital gains that are taxed as regular income, the tax savings can be significant.
For example, if someone in the 24% federal income tax bracket offsets $10,000 of short term capital gains, they would save $2,400 in taxes!
Even if you don’t have capital gains to offset, you can still use tax loss harvesting to avoid paying income tax on up to $3,000 of regular income every year, or carry the losses forward into future years.
If you have made a bad investment and want to sell that loss making or high risk investment, tax loss harvesting makes the loss more bearable by converting the loss into an opportunity to lower your tax bill while diversifying into more stable investments.
Offsetting capital losses from securities isn’t limited to capital gains from securities – it can also be used to offset capital gains from other investments like real estate or business.
What are the disadvantages of tax loss harvesting?
Although you can save on taxes in the short term, selling investments without much consideration can hinder a long term investment strategy by shifting your asset allocation and incurring transaction costs.
The process might also be challenging as it requires paying attention to tax rules – like the wash sale rule – in order to be profitable. Your loss will be disallowed if you or your spouse purchase the same or substantially similar security before or after 30 days of your sale.
Also, there are state specific rules and if a state doesn’t allow you to carry forward a tax loss, it may not be very beneficial.
Similarly, if you are in a lower tax bracket, the potential tax savings may not be significant.
Remember, tax loss harvesting postpones – but does not eliminate – your taxes. When reinvesting your proceeds, you might be effectively reducing the cost basis of your replacement securities, which will lead to a larger capital gains tax in the future.
Lastly, the best investment strategy for individuals involves holding investments for the long term, in which case tax loss harvesting wouldn’t actually save that much money due to the lower long term capital gains tax rates.
Should I use tax loss harvesting?
If you are buying and selling investments frequently (within one year of buying them) and are in a high tax bracket, tax loss harvesting can be a great tool to help you keep more of your profits.
But for individual investors who are in a lower tax bracket or are investing for the long term, tax-loss harvesting is an unnecessary complication that offers little benefit.
This is because of the lower long-term capital gains tax rate and the potential for worse overall performance caused by frequent trading.