As the year draws to close, it’s time to take stock of what you are doing to increase your overall tax efficiency. If you are looking to get a few more tax deductions, this is the time to do so, whether you are paying points for a mortgage or donating to charity. And another way you can increase your tax efficiency is to sell some of your losing investments. Do a financial checkup, and see what you can do to get ready for tax time. The deduction you get for selling your losing investments can dull some of the pain associated with a less than stellar year for your portfolio.
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Tax Loss Harvesting
Here are some of the basics of selling your losing investments:
- Use investment losses to offset capital gains: You can use some of your losses to offset capital gains taxes. This can help you reduce your capital gains, and lower the taxes you pay. You have to sell though; paper losses don’t count when it comes to tax filing. You have to sell — and clear — the stocks by the end of the year. If you have $15,000 in losses and $10,000 in gains, you can offset the gains, and still have $5,000 “left.”
- You can reduce your taxable income by up to $3,000 (if married filing jointly, $1,500 if single) with investment losses: So don’t get too carried away and sell everything. Carefully consider which investments to sell, and consider how they match up with your capital gains. In our example above, you can use $3,000 of that $5,000 to reduce your taxable income (use Schedule D for this). Even those in a lower tax bracket can see some savings.
- Carry your losses forward to another year: Since you still have $2,000 “left”, you can actually carry it forward to another year. This way you “bank” your losses for use another year. However, you should be careful; you are still limited on the amount you can reduce your taxable income by, so piling up too many losses can start to lose its luster. Carefully plan out how you will do this. It can be wise to sell investments you think are unlikely to recover in the future.
The Wash Sale Rule and Transaction Costs
Things to watch out for during this process include the IRS “wash sale rule” and transaction fees. Be aware that the IRS will disallow deductions on losses if you sell your stock and then buy something that is “substantially identical” within 30 days. If you plan to sell losing investments as a tax play, you have to be careful of what you buy for a month afterward. Additionally, you want to double check the transaction costs associated with the sale. In some cases, the cost of the transaction can reduce the overall value of your tax deduction.
Tax Loss Harvesting is NOT a Year-End Only Activity
One important concept that you won’t hear too much about is to tax loss harvest throughout the year and not just at the end of the year.
If you have an investment the lost a substantial amount of value, it is a good idea to lock in your loss now and replace it with another investment. There are so many investment options out there that it is not that difficult to avoid the wash sale rule, and by locking in your loss now, you are guaranteed to capture some tax savings.
Another reason you may want to take your losses before the end of the year is to make sure that you have short-term losses to offset short-term capital gains (which is taxed at a higher rate). On the other hand, if you wait until the end of the year, you may lose the opportunity to sell your losing investments.
Overall, this is no brainer move because you can capture your losses while keeping your money fully invested.
Consult a Tax Professional
It is a good idea to talk to a trusted tax professional about your options as you contemplate how you can dull the pain of an investment loss. At the very least, you should formulate a plan that allows you to take best advantage by getting rid of investments that are unlikely to succeed going forward and matching them up with some of your capital gains. Tax efficiency is a bit of an art, but with some research and/or professional help, you should be able to streamline things so that you owe less than you thought.
Miranda is a professional personal finance journalist. She is a contributor for several personal finance web sites. Her work has been mentioned in and linked to from, USA Today, The Huffington Post, The San Francisco Chronicle, The New York Times, The Wall Street Journal, and other publications. She also has her own personal finance blog: Planting Money Seeds.