We’re coming up on the busiest time of the year: tax season.
While it’s important to start filing your taxes as soon as you receive your W2, there are other considerations to ensure that you receive the best return and lower your tax liability as much as possible.
Investments can be a tricky subject when it comes to filing your taxes. Quite obviously, the top priority when investing is to yield the highest return possible — you wouldn’t buy stocks if you lost money every single year, right?
But the same logic could be reversed during tax season, meaning that if capital losses are significant, you may want to consider the tax swap strategy — sometimes known as tax loss harvesting — to balance your gains and losses.
What is Tax Loss Harvesting?
Simply put, Tax Loss Harvesting is a strategy that sees an investor selling their investments at a loss and investing in an equitable venture. Often utilizing a mutual fund, the strategy allows the investor to have a documented & realized tax loss without significantly affecting their investment position.
Here’s an example: let’s say you’ve invested $20,000 in FGH Mutual Fund, but now your investment is only worth $10,000. If you sell your holdings, you are taking a $10,000 capital loss. Then, let’s say you take that $10,000 and put it into ABC Mutual Fund with a similar-but-not-identical yield. Ultimately, your position would be the same, and you’re still able to participate in investing while also taking the tax benefit of your capital loss.
How It’s Used:
Any realized capital losses in the tax swap strategy could be used to offset your capital gains from concurrent investments. Alternatively, it could allow the taxpayer to use a taxable loss and apply to future tax periods, known as a Capital Loss Carryforward.
If you have a net capital loss, you can also deduct up to $3,000 against ordinary income, or $1,500 each for married couples who file separately.
The Wash Sale
There are rules when trying to take part in a tax swap strategy. A regulation of the IRS, the “Wash Sale” rule prohibits an investor from recognizing capital losses if they invest in a substantially similar investment within a 30-day period. That means that if an investor is looking to reinvest their capital losses, they cannot do so for at least a month without forfeiting the tax deduction from the initial capital loss.
The General Rule
Tax loss harvesting may be beneficial for investors looking to balance their expenses at tax season. You have to be smart about these decisions, though, and attempting to quickly move from one investment to another to take advantage of the tax swap strategy could cause more harm than good.
If you are looking to use a tax swap strategy this tax season, make sure that you have a timeline in place so your losses are appropriately documented and do not interfere with future investments. Furthermore, proper research helps investors understand where their money can go to yield similar gains once the 30-day period from the initial capital loss is realized.
Not sure what strategy is right for you? Talk to an LPSC Financial advisor before you make a final decision
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Sources
https://www.cnbc.com/2022/06/08/this-strategy-turns-losses-into-tax-brea...
https://www.schwab.com/learn/story/how-to-cut-your-tax-bill-with-tax-los...
https://www.investopedia.com/terms/w/washsalerule.asp