The fall harvest is in full swing and will shortly be coming to an end. This is also a great time of year to do some financial harvesting to help you pay less in taxes.
If you are the owner of a non-retirement account, you could stand to benefit from a concept we call “tax-loss harvesting.”
If you have a well-diversified portfolio, you in essence have different “crops” inside your account. Each year one crop may do better than another. You can use the proceeds from the well performing crop to offset the losses in the poorly performing crop. In investing we use the losses from the poorly performing crop to offset the taxes that you would normally pay on the crop that had a bountiful harvest.
Without getting too technical, here is an explanation of how taxation works in non-retirement accounts. Keep in mind this doesn’t apply to retirement accounts like an IRA or a 401(k), which are only taxed on the amounts withdrawn.
Each year in non-retirement accounts you are taxed on dividends and interest, just like you are taxed on interest you earn in the bank. There may also be a capital gain; for example, selling a piece of land for more than you bought it. Capital gains like this are only taxed in the year in which the asset is sold. Where tax-loss harvesting helps is using capital losses in some investments to offset the gains in other investments.
Let’s say you have an investment that made $10,000 this year. First of all, congratulations! If you sell that investment you may pay $1,500 in taxes. However, if you have other investments that have lost $10,000, you can sell those investments to offset the gains in the other investment. This would save you $1,500 in taxes. The proceeds can then be invested in a third investment for future growth.
If you have a bad stock-market year and you only have losses, there is still a silver lining: each year you can still offset your ordinary income by up to $3,000 in losses. If your losses are greater than $3,000 you can carry the losses to the next year, or until you have capital gains that will offset the losses.
There are some limitations imposed by the IRS to prevent people from selling and repurchasing the same investment to realize a gain or loss. If this transaction is done within 30 days it is considered a “wash-sale” and your purchase/tax benefit will be disallowed. You can, however, purchase a separate, unrelated investment to avoid the wash-sale rule. Much of the time, this isn’t necessary as an individual will have enough investments with gains and losses to offset each other.
As the fall harvest comes to a close, be sure to look at your non-retirement accounts to see if there is some harvesting you can do to save yourself on taxes. As always, you can contact one of the friendly representatives at Smedley Financial to see if tax-loss harvesting would benefit you.