While the markets may be underperforming this year, the bright side is that investors can sell securities that are losing money to offset their capital gains. This tax loss harvesting strategy helps to minimize tax burdens, easing the struggle consumers have when dealing with such a tumultuous year with the markets.
Tax loss harvesting, however, is only effective for taxable investment accounts. Done correctly, this strategy helps investors refocus attention on past progress. Investing is all about the long game, and that’s why it is so important not to dwell on temporary losses and financial setbacks.
While tax loss harvesting favors wealthy families, the strategy relies upon numerous factors that can spell out tax benefits for lower-income families as well. Outside of taxable income, additional factors include the allocation of assets, an individual’s time horizon, and tax rates.
If you plan to take advantage of tax loss harvesting, you must be aware of what’s called the wash sale rule. This rule prevents investors from buying a security within 30 days of having sold the same security at a loss for tax purposes.
This rule helps the SEC prevent investors from offsetting gains with losses if those investors plan to turn around and buy the same security days later to ride the rebound for profits.
3 Key Tax Strategies for Investors
Tax Swapping
Tax swapping is perhaps the easiest way for investors to minimize tax burdens without also missing out on a market rally. To execute this strategy, an investor would place a sell order for the original investment. A replacement asset is then purchased using the proceeds. It is wise for investors to choose securities that are in the same sector and class.
For example, a person might sell Home Depot (HD) only to turn around and purchase shares in Lowes (LOW). Finding a replacement investment prevents an investor from falling victim to the wash sale rule.
Doubling down
In some instances, investors do not wish to choose or are unable to find a replacement investment in the same sector and class of the security being sold. Investors can always wait 30 days after selling an investment to repurchase and prevent consequences of the wash sale rule, but doing so can also mean that these investors leave potential capital gains on the table.
The doubling-down strategy solves this problem. Simply put, to double down, an investor first purchases additional shares of a company before selling the original shares. You must wait an additional 30 days, however, before making that sale. Additionally, this strategy requires an investor to have extra capital on hand to make the preemptive purchase.
Waiting 30 days to sell also comes with possible consequences in the form of additional losses. If the price of a particular security was to continue dropping during the 30 days, an investor would incur a greater loss. A rally during the same 30-day period could mean an investor is unable to use the doubling-down strategy to offset capital gains.
Tax Overlay Strategy
Consistent tax loss harvesting trades on a smaller scale help investors offset capital gains. This preferred strategy complements the market, which typically ushers in short-lived losses but continues to move on up over longer periods. Using the tax overlay strategy, all portfolio adjustments are made with tax loss harvesting in mind. This type of systematic approach can help minimize tax burdens for investors.
Not only does the tax overlay strategy provide investors with a better approach to loss harvesting, but it also helps minimize the impact of capital gains on portfolios as well. For example, trades can be postponed if investors are about to deal with long-term vs short-term capital gains.