Lemons into lemonade. Clouds with silver linings. Investment losses into tax savings? Every investor will experience investment losses and feel the disappointment of seeing their wealth diminish periodically. But it’s possible to take steps that are advantageous to wealth enhancement even in periods of market downturns. One such strategy is tax loss harvesting (TLH).
At first glance, TLH can appear to be the opposite of what an investor would naturally want to do when their investments take a hit. But rather than hold the devalued investment, TLH allows you to strategically sell at the lower price creating capital losses for tax purposes that can be used to offset capital gains in other portions of your portfolio, offseting taxes you would otherwise pay as a result of these capital gains. There are a few things to keep in mind.
The ‘Wash-Sale Rule’ was devised to ensure that investors were not harvesting losses merely as a tax avoidance strategy, or “sham transaction”. It prohibits a taxpayer from claiming a loss on the sale or trade of a security if they purchase a “substantially identical” security within 30 days. Since most investors don’t want to lose their position in a given market simply to lower their tax burden, an investment manager can help allocate the cash resulting from TLH to similar stocks or securities, maintaining position in the market and avoiding a wash sale.
Recent tax changes also come into play. The American Taxpayer Relief Act of 2012 (ATRA) introduced a new top capital gains bracket of 20% applying to thresholds of $400K for individuals and $450K for married couples. In addition, as part of the Patient Protection and Affordable Care Act, a 3.8% Medicare surtax on “unearned” portfolio income—including annuities, dividends, interests, passive income, rents, royalties and any taxable capital gains—were added. This tax applies to thresholds of $200K of Adjusted Gross Income (AGI) for individuals and $250K of AGI for married couples. So how does this tie into TLH?
Let’s say a married couple has $251K of AGI after deductions—just over the threshold. Their 15% tax rate just went up to 18.3% thanks to the Medicare surtax! But TLH may reduce their AGI, allowing them to stay in the 15% bracket. The same is true of an individual who has $425K in AGI. But they face an even steeper increase with both the Medicare surtax and the new 20% long-term capital gains tax rate. All told, taxpayers in the highest bracket will face a combined 43.4% marginal tax rate on their investment income such as short-term capital gains, dividends and interest as well as a 23.8% tax on all long-term capital gains! For these investors TLH could make a huge difference.
As you can see, TLH is an important tool that can help the overall enhancement of wealth, in spite of periodic investment losses. It requires an open-eyed view of historical market behavior ; investors need to be implementing long-term strategies when considering their overall financial situation. This is the big picture: TLH can help you offset otherwise taxable gains with losses, helping to enhance your overall net worth. That’s how you can view investment loss as an opportunity, and you can take that to the bank.
Before implementing any specific tax strategy, investors should consult with their tax advisor to see how any actions will apply to their specific circumstances.
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