Even in the best of times, not all your investments are going to be winners. However, even falling investment values have a silver lining. The losses you earn on your portfolio can be used to lower your tax liability and position your portfolio better for the future. This particular strategy is known as tax-loss harvesting. Many investors use this tax-loss harvesting strategy annually to offset realized gains with losses earned from some specific investments. Tax-loss harvesting can offer a huge tax benefit if properly applied.
Here is what you need to know about tax-loss harvesting and its importance in your retirement plan:
Tax-loss harvesting strategy can help you minimize your yearly tax liability by offsetting your capital gains with specific investment losses. As per this tactic, you sell investments (such as stocks, mutual funds, exchange-traded funds, etc.) that have lost value to counterbalance any capital gains realized from other investments. You can also choose to replace the loss-bearing investments with reasonably similar options that meet your investment needs and asset allocation strategy. Moreover, tax-loss harvesting is useful in limiting short-term capital gains because they are taxed at a higher rate as compared to long-term capital gains. That said, it is now also useful to balance capital gains in the long-term too. This strategy is most suitable if applied during the initial life of a portfolio.
Tax-loss harvesting is based on a fundamental principle – increase portfolio losses to minimize the total burden of taxes. For example, if you invest in equity or equity-based assets, you will earn capital gains or losses depending on the market situation. In the case of capital gain, you would need to pay taxes on the earnings according to your investment bracket. However, if at the same time, some of your assets are underperforming or accruing losses, you can reduce the total capital gain tax liability by selling those loss-bearing assets. The tactic can be applied for short-term gains (earned on investments held for one year or lesser) or long-term gains (earned on investments held for longer than one year).
For 2020, federal tax rates for long-term capital gains are 20%. And the highest marginal rate for regular income is 37%. Since short-term capital gains are taxed at the marginal tax rate of normal income, the effective tax rate for short-term capital gains is 37%. That said, even though all investors can benefit from the tax-loss harvesting technique, this strategy is more beneficial for high-income investors.
Ideally, in a year, if your capital losses are more than capital gains, you can reduce your taxable annual income by $3,000 or your total net losses, whichever is lower. However, if you are married and filing a tax return separately, you can reduce your taxable income by not more than $1,500 in losses. That said, you can carry forward your unused loss amount into the future years in case your net losses exceed $3,000 in the current year.
Tax-loss harvesting is particularly significant for your retirement plan because of the many advantages it offers. Some of the most important benefits that tax-loss harvesting offers include:
For example, assume that you have a mutual fund that continues to increase in value each year for 20 years. During this period, you can use tax-loss harvesting tactics to offset your capital gains and defer final taxes for the future. By the end of 20 years, your funds grow by four to five times your actual investment, more so because you did not pay any taxes on the realized gains annually. This approach works like a tax-sheltered retirement account although your money is an ordinary taxable investment account.
Overall, tax-loss harvesting is a beneficial strategy for retirement planners. However, it is critical to understand the deeper aspects of the approach like the wash-sale rule that limits the buyback of similar or substantially similar assets, which were earlier sold for tax-harvesting purposes, for 30 days. Apart from this, the tax-loss harvesting approach can get slightly intimidating and difficult to apply in the case of multiple securities. Hence, it is advisable to consult a professional financial planner to guide you to make the best use of this opportunistic method.
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