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AllGen’s Co-Founder Jason Martin is back with a special year-end video about tax-loss harvesting and how it can be used to mitigate taxes from realized capital gains.

 

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the selling of securities at a loss in order to offset a tax liability from a capital gain, which is an increase in the value of an asset that is realized when the asset is sold. A capital gain or capital loss, which is the decrease in the value of an asset, can only be realized upon sale. Capital gains and losses that haven’t yet been sold are considered unrealized. Capital gains and losses that you have held for more than a year are considered long-term and typically have lower tax rates in comparison to short-term capital gains or losses, which are held for less than a year.

Tax-loss harvesting can be used as a method to potentially lower the taxes owed on capital gains.

How Does Tax-Loss Harvesting Lower Tax Liability?

If your account has funds experiencing capital gains, those gains will be taxed. Selling a fund that is trending down at a loss can lower the amount of tax on the overall account. However, a fund that has dropped in value may recover that value over time, and selling it would mean missing out on those gains. To prevent that, once the fund experiencing the loss has been sold, the money should be used to purchase another fund of similar value. The tax benefits of selling the fund with the capital loss are therefore realized while you don’t miss out on potential gains later on, allowing you to get the best of both worlds.

What Is the Goal of Tax-Loss Harvesting?

There are two major goals in tax-loss harvesting:

  • Reduce taxes by capturing losses to pair against gains
  • Maintain a diversified portfolio while not missing out on potential gains from the sale of a fund

The idea behind tax-loss harvesting is two-fold. The first step is to lower your tax liability by selling a fund that is currently down. The second is to replace that fund with a similar fund so that when the fund that is down goes up, you’ll benefit from the increase in value. The end result of the tax-loss harvesting is that less of your money has to go towards paying taxes and can instead stay invested.

What Are the Limitations of Tax-Loss Harvesting?

There are three primary limitations to the benefits of tax-loss harvesting. The first is that you can’t rebuy the same fund that you’re selling. This is called a wash sale and the IRS typically doesn’t allow tax benefits in a wash sale. There is also a limit on how much of a tax write-off you can have in one year. You can only use up to $3,000 in realized capital losses for tax purposes in a single year.

On top of that, for each transaction you make within your investments, there may be an administrative cost. Any tax benefits from tax-loss harvesting should outweigh any potential costs you might incur. It may be a good idea to pair tax-loss harvesting with portfolio rebalancing in order to reduce the number of transactions. Before you embark on any rebalancing or tax-loss harvesting, you should speak to your financial advisor.

 

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