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Tax Loss Harvesting: Improved Returns and Lower Taxes?

Many investors use tax loss harvesting as part of their overall investment strategy. When implemented correctly, tax loss harvesting can improve your portfolio's returns and reduce your taxable income. 

Sounds too good to be true? Wondering whether tax loss harvesting is right for you? 

Let's take a closer look.

What Is Tax Loss Harvesting?

Tax loss harvesting is the process of selling an investment at a loss to offset capital gains elsewhere in your portfolio or up to $3,000.00 of ordinary income if there not enough gains to offset. 

Tax loss harvesting is often used to reduce taxes in a taxable account, by leveraging any capital losses to avoid capital gains tax. However, it only works for taxable accounts because the loss is used to offset taxable gains, not tax-deferred gains of retirement accounts such as 401(k)s and IRAs.

Example Of Tax Loss Harvesting

For example, let's say you invested $2,000 into Stock A, but it is now worth $1,000. You have incurred an unrealized capital loss of $1,000 on Stock A.

You also own Stock B which you initially invested $2,000 into. It is now worth $2,500. You have an unrealized capital gain of $500 on Stock B. 

A loss of $1000 and a gain of $500 nets you $500 in losses. 

If you decide to sell both funds, you would not have to owe any taxes on the gains, and you would be able to reduce your taxable income by $500. 

But remember that you need to actually sell the stock to realize the loss for tax purposes.

Tax Loss Harvesting Rules For Individuals Vs. Married Couples

Individuals and married couples can both use tax loss harvesting, but you need to be aware of the different rules that apply. 

If you are single or a married couple filing jointly, you can realize capital losses to offset realized capital gains and/or offset ordinary income. Note that married couples filing jointly don't get to double the $3,000 limit on ordinary income. 

If you are married filing separately, each person can only deduct $1,500 of ordinary income.

Benefits Of Tax Loss Harvesting

There are several potential benefits of tax loss harvesting, including:

Improved after-tax returns: When you sell an investment at a loss, you can use that loss to offset any capital gains elsewhere in your portfolio. This reduces the amount of taxes you need to pay out of your portfolio's return, resulting in an improved after-tax return.

Portfolio growth:  Tax loss harvesting can also help maximize the growth of your portfolio by reducing the amount of taxes you need to pay each year. 

Carry over losses: You can carry losses exceeding the $3,000 maximum into the future to offset future gains.

Can be used with rebalancing: Portfolio rebalancing is important when it comes to maintaining your target asset allocation. However, it can create taxable gains. By harvesting losses first, you can offset these gains and reduce the taxes you owe.

Limitations To Tax Loss Harvesting

Of course, there are also limitations to tax loss harvesting that you should be aware of. These include:

Wash-sale rules: Tax loss harvesting cannot be used for "substantially identical" securities. This means that you cannot buy the same security back within 30 days of selling it at a loss and still claim the loss on your taxes. 

Only for taxable accounts: Tax loss harvesting cannot be used in retirement accounts like 401(k)s and IRAs. This is because these are already tax-deferred or tax-advantaged accounts.

Specific procedures: Short term losses must first be used to offset short term gains, and long term losses must first be used to offset long term gains. Then any remaining losses can be used to offset the other type of gain.

How Chatterton Can Help You Strategize With Tax Loss Harvesting

Tax loss harvesting is one strategy that can be used to improve your portfolio's returns and lower your taxes. There are processes to be followed, but if done correctly, tax loss harvesting may offer some significant benefits. Of course, there are also some limitations and in general, the technique will only be most beneficial if the tax benefits outweigh the costs of implementing the strategy. 

If you're curious about whether tax loss harvesting makes sense for you, contact us at Chatterton & Associates. Our tax professionals can help you understand the rules and navigate the complexities of tax loss harvesting. Ultimately, our financial planners in coordination with our tax professionals can help you come up with an investment strategy that makes sense for your specific situation and goals.


The Team at Chatterton & Associates

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc nor its representatives provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.

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