If you just look at the performance of the major indexes, this has been a pretty good year for the markets. But underneath the hood has been a narrow rally for most of the year. That means your portfolio may be sitting on a fair share of losers despite the headline numbers.
If you are sitting on some investment losses (which many folks are!), now may be the time to sell them and offset those losses against any gains you may have accrued in your portfolio via a strategy called tax loss harvesting.
Tax loss harvesting (also called tax swaps) is simply a tax-efficient strategy that involves selling taxable investment assets—including stocks, bonds, and mutual funds—at a loss, in order to reduce your tax liability. All you do is apply this loss against any capital gains in your portfolio, and that, effectively, will reduce your overall capital gains taxes.
[text_ad]
If you have had more losses than gains in 2023, the IRS will let you apply up to $3,000 in losses against your other income. And then you can carry over any remaining losses to offset income in the future.
Below is a graphic from Vanguard that gives a fair representation of what happens when you utilize tax loss harvesting.
Here are some examples of tax loss harvesting:
Scenario 1: You sell shares of XYZ Company and lose $4,000. Then you sell shares of ABC Company for a gain of $5,000. You’re ahead $1,000 and would normally pay capital gains taxes on that $1,000 gain. You have offset your total gain by the $4,000 loss you took on the shares of XYZ Company.
Scenario 2: Now, what if you actually lost $6,000 on the sale of XYZ Company shares? And let’s pretend that you still sold your shares of ABC Company for a $5,000 gain. So, you’re in the hole by $1,000. But the IRS lets you carry that loss over to apply to your regular income, up to $3,000 per year. So, you are effectively reducing your income.
Scenario 3: Next, let’s say you lost $10,000 on selling the shares of XYZ Company. And you still sold ABC Company shares for $5,000. Now, you have a net loss of $5,000. Well, the IRS says you can only use $3,000 of that loss to reduce your income this year. However, next year, you have another maximum $3,000 of offset. So, you can take the remaining $2,000 loss from this year and reduce your income by $2,000 next year.
Here’s a graphic from Schwab that demonstrates the mechanics of a tax swap.
The ultimate goal of using this tax loss harvesting strategy is to defer income taxes many years into the future, hopefully, after you retire, when you’ll probably be subject to a lower tax bracket. And along the way, your portfolio will continue to expand as you are deferring taxes on your gains, instead of depleting the portfolio to pay capital gains taxes each year.
This post has been partially excerpted from a previous article from Cabot Money Club Magazine. To read the full article, as well as other timely content about all things personal finance and investing, subscribe today!
[author_ad]
