Updated: Jul 7, 2021
As this crazy and unforgettable year comes to a close, it's time to start thinking about ways to save on the 2020 tax bill. As was mentioned in a previous blog, there are really only a few things to do after December to save on taxes. One of them -- tax-loss harvesting -- will require some investment decisions before the end of the year.
Sell for a loss???
One way to offset taxable income is to sell poor performing investments for a loss. When an investment has decreased in value, the sale can save you in taxes. This is called tax-loss harvesting. In doing so there are a number of significant benefits.
The loss offsets realized investment gains that would normally be taxed.
If the loss is more than the realized gains, it can offset up to $3,000 ($1,500 if married filing separately) of ordinary income.
Any excess loss above $3,000 carries over to the next year, and so on until the full amount of the loss is used up.
The cash left from the sale of the loss can be reinvested to keep working for you.
For example, let's say within a taxpayer's investment portfolio, they sold shares of ABC stock for a short-term gain of $2,000. Now lets say they also held XYZ stock that has severely underperformed and no longer fits their investment strategy. They sell their shares for a loss of $6,000.
The loss of $6,000 offsets the $2,000 gain (which would have been taxed as ordinary income as a short-term gain) along with $3,000 offsetting against their taxable income (provided there were no other realized gains in the year.) The remaining $1,000 of a loss is carried over to be used the following year.
In addition to the money saved in taxes, the cash position from the sale can now be used to buy a new position in another stock that is more promising. Or the cash can be saved and act as a cushion during a future market pull-back.
Warning of the wash sale rule
A wash sale occurs when you sell or trade securities at a loss and within 30 days before or after the sale, you buy a "substantially identical" security, or acquire through a fully taxable trade, a "substantially identical" security, or acquire a contract or option to buy a "substantially identical" security.
The IRS prohibits deducting losses from a wash sale trade. So when deciding what to sell, account for this rule so the loss can actually be deducted. After all, the goal is to turn something bad into something good, so make sure it counts.
Like what was mentioned earlier, the market has pull-backs, crashes, whatever you want to call them, and saving the cash for when this occurs can be a great way to recapture the loss that was just taken. After all, who doesn't like buying things on sale?
Don't undermine your investment strategy
Of course selling an investment isn't always the answer. Investing is long-term and the market has many bumps along the way. To sell a position that has dropped due to market volatility may not be wise if that company still has good value and potential.
Oftentimes when people panic sell from a dip in the market they end up regretting it later if the investment later rebounds . Therefore, don't undermine investment goals for a little tax savings.
With that said, an evaluation of a portfolio this time of year is always a smart idea. If it makes sense to sell off a lagging position, save on your tax bill, and have some extra cash for a portfolio upgrade, now's the time to do so.
If your investment advisor and tax preparer don't work together, feel free to reach out to us. We offer both services to our clients, and help them make balanced decisions for their personal financial situation.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing involves risk and you may lose your principal.