Strategies for Reducing Investment Taxes: The key focus should be on retaining your earnings, not just generating them.

Key Takeaways

• Investment losses can be utilized to reduce taxes by offsetting gains or income.

• Even without current gains, it is advantageous to harvest losses now, as they can offset income or future gains.

• If capital losses exceed gains, you may use up to $3,000 annually to offset ordinary income on federal income taxes, carrying over the remainder to subsequent years.

An investment that has depreciated in value can still serve a beneficial purpose—or at least mitigate its negative impact. The approach that transforms a loss-making investment into a tax advantage is known as tax-loss harvesting.

Tax-loss harvesting can assist in reducing your current and future tax liabilities.

This strategy involves selling underperforming investments, replacing them with similar alternatives, and using the losses to offset realized investment gains. Consequently, a smaller portion of your funds is allocated to taxes, allowing more capital to remain invested and productive.

It accelerates investors' progress towards their financial objectives. If you have a financial advisor, they might already be implementing tax-loss harvesting on your behalf. If you are managing it independently, consulting a tax professional is advisable.

How Tax-Loss Harvesting Can Assist in Tax Management

An investment loss can serve two purposes:

• Losses can be used to offset investment gains.

• Remaining losses can offset $3,000 of income on a tax return within a year. (For married individuals filing separately, the deduction is $1,500.)

Unused losses can be carried forward indefinitely.

"Volatile markets, such as those experienced in 2020, 2022, and 2023, can present opportunities. Tax-loss harvesting is very episodic; when opportunities arise, we aim to capitalize on them. We allocate these additional losses to what we refer to as a 'tax savings account.' Your losses may protect your taxable gains for several years."

This approach is promising, but it is essential to understand the details to see how tax-loss harvesting might reduce your tax liabilities.

Short-Term Versus Long-Term Gains and Losses

There are two types of gains and losses: short-term and long-term.

• Short-term capital gains and losses arise from the sale of investments held for one year or less.

• Long-term capital gains and losses occur after selling investments held for more than one year.

The primary distinction between short- and long-term gains is the applicable tax rate.

Short-term capital gains are taxed at your marginal tax rate as ordinary income. The highest marginal federal tax rate on ordinary income is 37%.

For those subject to the net investment income tax (NIIT) of 3.8%, the effective rate can reach up to 40.8%. Additionally, state and local income taxes can increase these rates further.

However, for long-term capital gains, the capital gains tax rate applies, which can be significantly lower. When the 3.8% NIIT comes into play, the actual long-term capital-gains tax rate for high earners can be as much as 23.8%. And with state and local taxes added in, the rate can be even higher.

Gains and Losses in Mutual Funds

For mutual fund investors, long-term gains may be realized through mutual fund distributions. It is important to monitor the projected distribution dates for capital gains carefully. Any harvested losses can be utilized to offset these gains.

Moreover, mutual funds may also distribute short-term capital gains, which are considered ordinary income for tax purposes. Unlike short-term capital gains from the direct sale of securities, investors cannot offset these with capital losses.

Enhance Your Tax Savings by Harvesting Losses

Identify investments that no longer align with your strategy, have limited growth potential, or can be easily replaced to optimize your tax-loss selling strategy.

Maximize your benefits by focusing on short-term losses, as they first offset short-term gains, which are taxed at a higher marginal rate.

The tax code requires using short- and long-term losses to offset gains of the same type first. If your losses exceed gains of the same type, apply the excess to the other type. For instance, a $15,000 long-term loss with only $5,000 in long-term gains allows you to apply the remaining $10,000 to offset short-term gains.

If you have short-term losses but only unrealized long-term gains, consider realizing those gains later. While applying short-term losses to long-term gains is less effective, it may still be preferable to paying long-term capital gains tax.

Even without realized capital gains, capital loss deductions and carryover provisions make realizing a capital loss effective. The tax code permits joint, single, and head of household filers to apply up to $3,000 in remaining capital losses after offsetting gains to reduce ordinary income.

Carry forward any remaining capital losses for future use after applying them to capital gains and ordinary income.

Maintain Diversification and Avoid Wash Sales

After deciding which investments to sell for losses, carefully select new investments, ensuring compliance with the wash-sale rule.

The wash-sale rule disallows tax write-offs if you buy the same or "substantially identical" security within 30 days before or after selling the loss-generating investment. Those with stock or stock-like bonuses should consider vesting or ESPP purchase dates within this window.

To avoid wash sales on individual stocks, consider substituting a mutual fund or ETF targeting the same industry.

If uncertain, consult a tax advisor before purchasing.

Note: Wash-sale rules don't apply to cryptocurrencies, allowing you to sell and repurchase coins at the same price, realizing the loss while retaining the asset. Pending legislation may change this, so consult a tax professional for updates.

Integrate Tax-Loss Harvesting into Year-Round Strategies

Maximize tax-loss harvesting by incorporating it into your year-round tax planning and investment strategy. I avoid large-cap fund of funds, opting for individual investments to enhance tax efficiency. Investing in individual large-cap value, core, and growth funds allows for tax-loss harvesting as securities and styles fluctuate.

I carefully avoid wash-sale rule violations, selecting positions that are easily replaceable, such as energy ETFs similar in risk and return.

Tax-loss harvesting naturally aligns with portfolio rebalancing, providing opportunities to reassess and harvest losses from underperforming investments.

If your employer offers stock bonuses, selling for a tax loss before new awards can prevent excessive concentration in company stock.

Choose the Best Cost Basis Method

Review how your investment cost basis is calculated. Cost basis includes the purchase price and brokerage costs or commissions.

For multiple lots of the same security, cost basis can be an average of all purchases (average-cost method) or track each lot's actual cost (actual-cost method).

The actual-cost method allows you to designate specific higher-cost shares for sale, maximizing realized losses. Learn more about capital gains and cost basis.

Prioritize Your Investment Goals

Remember: Don't let tax considerations overshadow investment goals. Implement tax-loss harvesting wisely, ensuring it aligns with your investment objectives. A balanced strategy and regular evaluations are key.

If you're interested in tax-loss harvesting but need assistance, I'm here to help.

Best Regards,

Stock Market Charlie aka The Hound of 317