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Around this time of the year, people like to discuss ways to lower their tax bills. The reason? Deadlines are approaching on December 31st such as 401k and charitable contributions. More notably, it's the same deadline for capital gains transactions in 2022. Towards the end of the year, people strategically attempt to lower their tax bill with their capital gains and losses. This process is called "tax-loss harvesting".
First, what is a "capital gain"? These are profits that are realized from selling or trading "capital assets" such as stocks, bonds, and real estate. When investors sell their capital assets, they are treated as either short-term or long-term. If the asset is held for less than a year, it's treated as a short-term capital gain. Short-term capital gains are taxed based on the ordinary income tax bracket of the owner. If the assets are held for more than a year, it's treated as a long-term capital gain. Long-term gains have a specific capital gains tax bracket. For example, on a federal level, those brackets are 0%, 15%, and 20% depending on where both the investor's income and total capital gain are realized for the year. Short-term capital gains and losses offset each other while long-term capital gains and losses also offset each other. These two numbers are then netted against each other. If the total is a loss, that amount can be deducted up to $3,000 for the year (Married filing separately is $1,500 each*). People use this tax benefit to their advantage for tax loss harvesting.
It’s a process to deliberately sell losses with the intent of lowering an investor's tax bill. Again, people can deduct up to $3,000 in capital losses for the year. Anything above that amount gets carried over into the next year. For example, suppose someone has $4,000 in unrealized capital losses (Unrealized = Not sold yet so not subject to taxes, Realized = Sold, so subject to taxes ). They decide to sell all these losses and “realize” them for the year. This year they can deduct $3,000 from their tax return. The remaining $1,000 is carried over into the next year and will be deductible in next year's tax season.
Someone might say, “Shouldn’t a long-term investor be holding for the long term? Shouldn't they hold no matter what?” Well… drum roll please*…that depends. Holding an index fund is different from holding an individual stock. Holding a stock with weaker fundamentals is different from one with stronger ones. The list goes on. What this ultimately does is provide closure to certain positions that an investor does not have full faith in while also benefiting from a tax deduction. This doesn’t mean they are trying to sell everything in their portfolio. But rather, they are cleaning out their portfolio by getting rid of specific losers so they can focus on the investments they still would like to hold long-term. Big difference.
This may also be an opportunity to take wins in a tax-efficient manner. There may be some positions that have been held for years where an investor may want to sell a position. A reason could be to shift towards less risk or more diversification. By strategically realizing losses, an investor could shield this new gain from a taxable event. For example, let's say an investor had these two stocks: Stock A has an unrealized $10,000 capital gain & Stock B has an unrealized $12,000 capital loss. Selling all of Stock A alone would realize a capital gain of $10,000 and incur a tax bill for it. By using the losses from Stock B, an investor can “shield” the gain from Stock A from being taxable by realizing some or all the losses from Stock B. In addition, by selling Stock B altogether they could avoid paying taxes on the gains AND receive a $2,000 deduction too. It’s a great way to restructure a portfolio in a tax-efficient manner!
This will only work with taxable accounts such as a standard brokerage account since it doesn't defer taxable transactions. Accounts like a 401k, IRA, Roth IRA, or other tax-advantaged accounts are either tax-deferred or tax-free. So while they might not realize any gains in the same year, it's also true that they would not realize any losses in the same year. This is another reason to diversify in the form of taxes, especially with the help of a tax advisor and a fiduciary. It's not just about how much someone can accumulate. It's about how much they can keep while distributing their funds too. Tax diversification helps.
With the end of 2022 coming up, it's a great time to start working on a plan for 2023. Need some help putting yours together? Only have a few time slots left for the remainder of the year. Schedule a complimentary consultation here!
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