With the end of 2016 coming near, many investors are looking at strategies that may reduce their upcoming tax bill. Each year there are strong performing asset classes as well as some asset classes that may see negative returns. If you hold any assets with negative returns, you may actually have an opportunity to harvest those losses and save some money on future tax bills. While we always wish to have gains in our investment accounts, we know that losses do happen. Harvesting losses for tax purposes may be a way for you to take lemons and make some lemonade. This strategy works for non-qualified accounts, or accounts that aren’t held in tax-deferred status (Tax deferred accounts include: IRAs, 401k, 403b).
What is a Capital Loss?
When you see appreciation in your investments, the difference between the most recent net asset value of the investment and the price at which you purchased it is your unrealized capital gain. Similarly, when you have a fund that is worth less now than when you initially purchased it, you have an unrealized capital loss. Selling either of the funds in the previous scenarios results in a REALIZED gain/loss. Any investments that are purchased and sold within a year’s time results in a “short-term” gain/loss. Longer than one year’s time between the purchase and sale results in a “long-term” gain/loss. Knowing the unrealized capital gains/losses in your taxable accounts can open up opportunities for you to do some tax planning.
Why Capture Capital Losses?
If you have investments that are currently at a loss, you can sell these investments to REALIZE that loss. Well, why would I ever want to realize a loss? Your losses will offset any gains that you have realized. So if you have $1,000 in capital gains this year, and sell an investment that has a $1,000 loss, they cancel each other out and you can avoid paying the tax on those gains. (Click here for tax rates on Capital Gains.) If you are in the 25% tax bracket and have a realized long-term capital gain of $25,000 from the sale of a business asset and can realize a long-term capital loss of $25,000 from an underwater mutual fund, you have just offset $3,750 in taxes!
You can offset as much gain as you want in a given year, if you have losses to match. If you have more losses than gains, the loss amount can reduce your ordinary taxable income. This is limited to $3,000 per year. If you are in the 25% tax bracket, you could save yourself $750 by reducing your ordinary income by $3,000. Hey, that might cover your tax prep for the year and leave room for a few DQ blizzards! (go with Reese’s, it never disappoints.) Say you have $50,000 in losses realized– you can “carry forward” these losses to use in future years.
Wash Rule- Investopedia definition : “An Internal Revenue Service (IRS) rule that prohibits a taxpayer from claiming a loss on the sale or trade of a security in a wash sale. The rule defines a wash sale as one that occurs when an individual sells or trades a security at a loss, and within 30 days before or after this sale, buys a “substantially identical” stock or security, or acquires a contract or option to do so. A wash sale also results if an individual sells a security, and the spouse or a company controlled by the individual buys a substantially equivalent security.” You want to avoid the wash sale. One way to do this is to sell a Large Cap Growth from one fund family at a loss, then purchase a Large Cap Growth fund from a different fund family to keep your investment policy intact while still harvesting the loss.
How is it reported on my taxes? Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13 of Form 1040.
Are you in the 10% or 15% tax bracket? It is smart to realize your long-term capital gains each year. You just want to make sure that the total amount you realize doesn’t push you into a higher bracket. Capital gains for these brackets are exempt from capital gains taxation!
Is your advisor working with you on strategies to lower your tax bill? Click here.