As a taxpayer, one of your primary objectives is to lower your tax liability toward the government.
There are many legal ways to do this: IRA contributions, charitable donations, and contributions to 401(k)s are all good examples.
There is also another way, a strategy called tax loss harvesting.
Here are critical facts about tax loss harvesting to know if you are considering using this strategy to reduce your tax burden.
What is tax loss harvesting?
Your objective is to deliberately sell an investment at a loss. You then use that capital loss dollar for dollar to offset any capital gains you made on your investments. This can reduce the amount of taxes owed that year.
What is the logic behind using tax loss harvesting?
The answer is simple: You can use your tax savings from the current year to make additional investments and generate more wealth in your portfolio.
The extra dollars you create in this manner could be more than the amount you finally pay the IRS as tax on your other gains.
Is tax loss harvesting useful for all taxpayers?
No, this is a very situational strategy. You can only use it if you have a taxable investment account.
It works best if your investment account has a longer investment horizon.
Does tax loss harvesting affect personal income tax burden?
Yes, tax loss harvesting can reduce taxes owed on your personal income. If your capital losses exceed all gains made in the year in your investment account, the excess can be used to offset your personal income instead.
The annual income tax deduction limit is $3,000 ($1,500 if you are married but file separate returns).
However, if you have more than that in losses, the benefit can be carried over into future years.
What is the best time to utilize tax loss harvesting?
Many investors wait until the end of the year before attempting to offset the looming capital gains tax.
But this is not an optimal strategy. Ideally, you should be on the lookout for stocks to sell in your portfolio throughout the year.
That way, you will not miss out on great opportunities. The bigger the loss, the greater the benefit.
Is tax loss harvesting approved by the IRS?
As long as you stick to the approved limits, tax loss harvesting is indeed a legal strategy under IRS regulations.
There is one important restriction that should never be violated: you cannot immediately buy back a stock after dumping it for the explicit purpose of tax loss harvesting. You must wait 30 days, though you can immediately buy a different stock if you like.
This is called the “wash sale rule.”
