Home Taxes What Is Tax-Loss Harvesting And How Does It Work In 2022?

What Is Tax-Loss Harvesting And How Does It Work In 2022?

by Amarachukwu
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Losing money is not planned especially when it comes to investment, but it is also sometimes inevitable. When you start investing, some stocks will do well and some will not, but this doesn’t mean you can’t bounce back to your feet and turn your losses into wins.

According to Investopedia, Tax-Loss Harvesting or Tax Loss Selling is selling securities at a loss to offset a capital gains tax liability. Offsetting gain is a situation where losses made in investment are made up for by gains in another investment. 

Tax Loss harvesting allows you to sell investments at a loss and replace them with good investments. This allows less of your money to go into taxes and more to stay invested. One benefit of tax loss harvesting is that it helps reduce your taxes in the future.

How Does Tax Loss Harvesting Work?

Tax-loss harvesting allows investors to reduce the taxes they owe on any capital gains. It also helps in good investment returns since it involves selling your investment losses and replacing it with a similar investment. Tax Loss Harvesting is a strategy and can only give you many benefits if you do it the right way. Before you think of engaging in tax-loss harvesting, you should note few things;

  • You will run at a loss if you sell securities for less than what you paid.
  • You can only benefit from tax-loss harvesting if you sell your securities for more than what you paid.
  • Leaving your lost investment without doing anything is more loss. So you can only gain more when you sell your losses.
  • Tax Loss Harvesting is a strategy when it comes to achieving your financial goals and should be a major part of your financial planning. According to gobankingrates, an example of tax loss harvesting is this;

If you buy shares for$10,000 and another for the same $10,000. After a few years, the first share is worth $13,000 and the second is worth $7,000. This means that the first shares gained $3,000 and the second lost $3,000 in the same year and time frame. This loss offset your gains making you owe $0 in taxes.

On the other hand, if the first share jumps to $13,000 but the second one drops to $5,000, then you have capital gains of $3000 but lose $5,000 for a loss of $2,000.  Your benefit here is that you do not only owe $0 in taxes, but you can also increase your taxable income by $2,000.

Tax-loss harvesting is simply selling an investment that is losing money or not gaining capital, using that loss to reduce your tax and offset your gains to $3000 of your income and finally reinvesting the money made after selling your investment into another stock that matches your investment needs.

Tips To Consider In Tax Loss Harvesting

Because tax loss harvesting has a lot of pros and cons, you have to consider it carefully since it is sometimes not an effective strategy when it comes to investment.

Understand That Not All Income Is Taxed Equally

The IRS issues, taxes according to your income. The rate on an ordinary income which includes short-term capital gains is 37 percent, while the rate on long-term capital gains is 20 percent. This means that if you have long-term capital gains and you are hoping to generate more short-term capital gains, it is advisable to harvest your losses this year so by next year you offset the short-term capital gains.

Tax Loss Harvesting Is Advisable To only Long Term Investors

The value of tax-loss harvesting increases as your investment increases, especially if you keep investing for a long period of time. If you invest for only a short period or even for a period of one year, there is hardly any benefit to tax-loss harvesting. This means that tax loss harvesting is only beneficial to those who want to invest for a long period of time.

You Get More Benefit From Tax Loss Harvesting If You Deposit Consistently

Depositing consistently to your investment increases your chances of benefits over time because the higher the number of deposits, the higher the benefits of tax Loss Harvesting.

Tax Loss Harvesting Works For Both Retirees

If you save long-term until retirement, the greater your benefit of tax-loss harvesting. It is not possible to withdraw all your investment once you have retired but there is a possibility of you withdrawing small amounts once in a while. As long as you withdraw and also deposit, it increases your chances of benefits.

Tax Loss Harvesting Creates Value in Both Up And Down Market

Tax-Loss Harvesting is not only done on a yearly basis. Daily tax-loss harvesting helps you look for losses daily that must not be there at the end of the year. So it is not advisable to create tax-loss harvesting opportunities for just the end of the year.

It Is More Useful If You’re Investing In Individual Stocks

Consider focusing on a particular niche when investing because it helps in managing tax Loss Harvesting. If you decide to invest in different stocks, then you should invest via a robo advisor.

How To Use Tax-Loss Harvesting

Figure Your Gains And Losses

If you want to increase your benefit in tax-loss harvesting at the end of the year, then you need to calculate how much you have gained and how much you have lost in that year. For example, if you gained $10,000 dollars in that year and you still need to gain an extra $2000 before the end of the year then you need to expect a total gain of $12,000.

Use the 30 Days Rule

After deciding how much you want to sell, you need to calculate the transactions in your investment account before the end of the year and make sure you wait for at least 30 days to avoid the wash sale rule.

What To Avoid When Using Tax-loss Harvesting

Wash Sale Rule

According to Forbes, a wash sale is when you sell an investment and then immediately purchase an investment similar to it for the same price. It becomes a wash sale because it has no effect on the performance of your investment portfolio. If you end up buying a similar investment within 30 days you have to wait for another 40 days before selling it off to recover your tax benefit.

Avoid Selling Because Of Tax Break

Investments tend to have more capital gains when kept fir a long period of time. Although it is tempting to sell an investment just because of the tax break, you cannot tell the future gain of the investment. If there is nothing wrong with your investment, it is advisable to hold on for a long time before selling. The main aspect in tax loss harvesting is selling investment losses just to take advantage of the losses on your taxes and then buying another investment that is not similar to the one you sold just to avoid wash sales.

Benefits Of Tax-loss Harvesting

  • Helps investors minimize what they invest in capital gains
  • It helps in reducing tax liability on investments.
  • It is useful when it comes to financial planning and budgeting.
  • Helps in improving overall returns

What To Note In Tax Loss Harvesting

  • Tax Loss Harvesting is a good way to reduce your tax bills by selling your investments at a loss and in turn the losses will be deducted from your taxes. 
  • Most investors who want to improve their investment portfolio focus on tax loss harvesting at the end of the investment year because selling stocks with lesser value brings higher returns. 
  • Short term capital gains are benefits or losses gotten from selling investments you have owned for a period of one year while long term capital gains and losses are benefits or losses gotten from selling investments you have owned for a long period of time. You can harvest both short term and long term capital gains but it all depends on your tax income.
  • You can get up to $3000 in a year from tax loss harvesting but it all depends on the size of your account.
  • If an investment drops, you can deduct it from your capital gains which in turn will help boost your investment portfolio.
  • As long as the world population is increay, the value of money will keep decreasing so if you save up to $3,000 from taxes now for the next ten years and still pay $3000 after the period of ten years, the value in the $3000 you said will depreciate. 

Another thing to note in Tax Loss Harvesting is that an investment that has lost value can still help your investment portfolio because it is not considered a loss until it is sold for an amount lesser than the amount used in purchasing that particular investment. This is why it is only advisable to sell an investment for a higher price than the amount used in purchasing it.

Conclusion 

Tax-loss harvesting is a great way to reduce your taxable income and save money on your taxes. It can be a little complex, but we’ve broken it down for you in this post. In short, tax-loss harvesting is the process of selling securities that have lost value and using the resulting capital loss to offset any capital gains you may have realized during the year.

Let me know what you think about tax-loss harvesting in the comment section below. Have you ever used it to reduce your taxable income?

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