When you think of this time of year and harvesting, your mind may go to crops and farming. But don’t forget about harvesting investment losses as well. This topic came up with a client recently who asked for a reminder on why it can be a useful strategy, especially in a down year such as 2022. Let’s review the highlights here but as always, your situation may vary and you should work with your tax and financial advisor before taking any action.
What are capital gains (and losses)?
Capital gains and losses represent the change in value of an investment security from the time you purchased it. If the price has increased, you have a gain – and if the price has decreased, you have a loss.
Wait – so any change in value is potentially taxable?
No! As the prices moves during the time you hold a security, those gains and losses are deemed unrealized and are not taxable events. It’s only when you realize a gain or loss (by selling the security, or by receiving a distribution from a mutual fund), that taxes enter the equation
Does it matter how long I hold the security?
Yes. If you hold a security for under a year and realize a gain/loss, it is deemed short term. Anything over a year is long term.
What implication do these capital gains and losses have on taxes?
That answer is a crowd favorite – it depends!
First off, capital gains and losses only impact you in taxable accounts. As a result, the gains and losses in a retirement account (such as an IRA, Roth IRA, 401k) aren’t taxable events (only withdrawals from certain types of etirement accounts trigger taxes – not gains/losses or income generated within the accounts).
Secondly, as noted above, gains and losses only become potential tax events when realized. Prior to a sale (ie: as you hold the security and the price fluctuates), these gains and losses are deemed unrealized. It’s the sale of the security that makes it realized and brings taxes into the forefront.
Lastly, the tax consequences of capital gains and losses depends on your overall tax picture – including your income, tax brackets, other capital gains and losses, and any prior year net losses.
What’s the tax rate in play?
Short term capital gains are taxes as ordinary income but long term capital gains may be taxed at 0, 15, or 20% – depending on your income level.
Do gains and losses offset one another?
Absolutely! It is a net calculation. If you have more gains than losses, you may be looking at net taxable gain in that year. If you have more losses than gains, you can deduct up to $3,000 of that net loss against your ordinary income and carryover the remaining amounts to future tax returns (to either offset gains or again be taken against ordinary income).
Keep in mind there is an order to the netting. A long-term loss would first be applied to a long-term gain, and a short-term loss would be applied to a short-term gain. If there are excess losses in one category, these can then be applied to gains of either type
How does harvesting fit in?
This is the idea of reviewing your taxable portfolio and seeing if there are any securities that may be in a loss position. If you do in fact have unrealized losses (ie: worth less than what you paid but not yet sold), you may consider selling them and realizing the losses. Why? You can use those losses to offset any realized gains (either on individual positions or distributed from mutual funds) – or worst case, take $3,000 off income this year and carry the losses to future years. Once sold, the loss is realized and you can reinvest the proceeds to maintain your investment allocation.
What do I need to watch out for?
Be careful how you reinvest the funds of securities sold. In order to get the tax loss (and avoid it being disallowed), you need to ensure that you do not reinvest the funds into a substantially similar security 30 days before or after the sale resulting in the loss. These are referred to as wash sale rules and deserve your full attention!
What should I do now?
As noted above, work carefully with your financial and tax advisor on this exercise. To prepare you for that, here is some homework items you can do in advance:
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