Downturns in the stock market usually spell doom for investors, but not always. Savvy strategies like tax loss harvesting can help you maximize long term gains in the face of an unfriendly market.
Unfortunately, tax loss harvesting isn’t exactly a self-explanatory concept, but we’re here to help. Here’s everything you need to know about how it works and how you can take advantage of it.
What is Tax Loss Harvesting?
Tax loss harvesting is also called tax loss selling, which might be a better way of thinking about the idea. Basically, the strategy involves selling assets at a loss in order to reduce some of your tax burdens.
The government taxes capital gains which are the profits you earn from the sale of investments. By selling some assets for a loss, you can offset any capital gains you may have profited on and lower your overall taxable income at the end of the year.
In practice, this can be hard to pull off manually. Luckily many robo-advisors incorporate tax loss harvesting into their strategies.
Who Takes Advantage of It?
Many investors capitalize on loss harvesting, but an imaginary example can help demonstrate exactly how it works.
Let’s say you have two taxable investment accounts, one that you can sell for $20,000 in gains, and another you can sell for $5,000 in loss. If you sell both accounts, you’ll net $15,000 in taxable income. That means at a 15% capital gains tax rate, you’ll lose $2,250.
If you didn’t sell your second set of assets, you would have been taxed that same 15% on $20,000 in gains, meaning you’d lose $3,000 to taxes. After 30 days, you can reinvest into similar assets, shielding yourself from potential tax losses without actually losing significant holdings.
Harvesting works best when done through a quality financial advisor or robo-advisor, since it can be difficult to manage on your own. Also, short term capital gains are taxed at a higher rate than long term gains. With that in mind, harvesting might make more sense for an investor with short term gains, so they can offset the more punishing taxes.
How Loss Harvesting Can Benefit You
The key to tax loss harvesting is that it essentially delays the capital gains tax you pay. By selling for a loss in the short term, you pay less in taxes and have more to subsequently reinvest. Over many years this has a compounding effect on your investments.
While the capital gains tax will inevitably get you, your investment fund could be exponentially larger by that time because of the harvesting strategy. Using more than a decade of data, Wealthfront estimated that tax loss harvesting can result in returns increased by more than 1 percent each year. For long term investments, that can make a serious difference in your yield.