Tax-Smart Investing: Your Ultimate Guide to Tax Loss Harvesting

Uncover the strategic advantage of Tax Loss Harvesting to optimize your tax liability. This comprehensive guide walks you through key techniques, ensuring your investment portfolio is tax-efficient and aligned with contemporary tax laws to enhance your after-tax returns.

Tax efficient planning should be a top priority for every serious investor, especially those with sizable portfolios. Capital gains taxes are due every year. There’s no way around it. For this reason, tax loss harvesting can benefit investors by allowing them to offset their tax burden on capital gains.

In years when your portfolio realizes a gain, tax-smart investing will allow you to balance those gains as a capital loss tax offset. While this may seem complicated, there are some ways to simplify the process through smart tax planning.

Let’s explore the ins and outs of Tax Loss Harvesting and its role in tax-efficient investing.

What is Tax Loss Harvesting?

Tax loss harvesting is the process of mitigating capital gains taxes by selling investments at a loss in order to offset gains in other investments. However, if your investments have not realized a gain in the year, you can carry over losses to future years.

Benefits of Tax Loss Harvesting

1. Saving on taxes: Why pay more taxes when you could reduce the burden by taking a loss in underperforming assets?
   
   
2. Risk management: Balancing a portfolio based on risk analysis can often save you money in the long run.
   
   
3. Re-investing: Taking the loss can free up cash in your portfolio to re-invest in better-performing assets
   
   

Taking a capital loss tax offset is the sensible course of action for many investors. It’s an important tool in wealth management and contemporary financial wisdom.

Understanding Capital Gains Tax

Capital Gains Tax is a government-issued tariff on all realized gains for any capital asset(s) that an investor or individual has owned. It can include anything from real estate, stocks, crypto, or any other asset. Simply put, when you make money on an investment, you have to pay taxes on it when you sell it.

Capital Gains Tax affects your investment returns depending on whether you’ve held those assets for short- or long-term gains. What’s the difference in short-term and long-term capital gains?

1. Short-term capital gains: assets that are held for a year or less and are taxed at normal income tax bracket rates (10%, 12%, 22%, 24%, 32%, 35% or 37%).
2. Long-term capital gains: assets held for more than one year and are taxed at a lower rate.

According to NerdWallet, these are the current rates for long-term capital gains:

Strategies to Mitigate Capital Gains Tax

It behooves investors to mitigate capital gains as much as possible. After all, who wants to pay more than their fair share of taxes, right? On that token, here are five proven ways to optimize your taxes and offset capital gains:

1. Utilize tax-loss harvesting by selling underlying investments and taking a loss on those investments to mitigate capital gains for the year.
2. Take advantage of tax-deferred retirement plans like IRAs and 401k plans where you’ll be shielded from capital gains tax liability.
3. Hold onto taxable assets for more than a year to avoid shorter-term capital gains rates.
4. Make donations to charity with investments that have realized gains in the year.
5. Move to a tax haven like Puerto Rico to qualify for lower tax brackets.

Tax Optimization Strategies and Techniques

Tax harvesting techniques must follow careful IRS considerations and rules for investors to remain tax compliant. Here are a few examples of things to consider before taking a capital loss tax offset:

Wash Sale Rules

Generally speaking, you cannot sell an investment at a loss and then repurchase it right after the sale (for up to 30 days). This is called a “wash sale,” and the IRS will not allow you to claim the loss. (There are some exceptions to this rule, but only for traders who’ve been designated as Mark to Market.)

Cost Basis

Realizing capital losses for tax benefits only comes once an asset has been sold. There are advantages to identifying which “lots” of your shares to sell, for this reason. For example, many investors will choose to sell shares on a “first in, first out” basis to show that their cost basis is higher. This is especially beneficial if you’ve added to your positions over time at different prices.

Timing Considerations

Identifying assets for tax loss harvesting can be as simple as taking a look at your portfolio, identifying which assets are underperforming, and cutting those positions. However, as we’ve mentioned before, you’ll want to consider whether or not you need to offset gains for the year. If so, selling your losing positions before the year-end might be a wise decision.

Record-Keeping and Documentation

To identify the type of assets and lots you want to sell, many brokerages may require you to be more “hands-on” with your record keeping. Most brokerages will simply default to the average price in your portfolio.

Be sure to keep meticulous records of your purchases so that you can identify specific lots of purchases at specific prices and request the best cost basis for tax loss efficiency. Ideally, you want the biggest bang for the buck in tax savings, but it may require more documentation on your part.

How to Build a Tax-Efficient Portfolio

The first step in building a tax-efficient portfolio begins with understanding just how detrimental taxes can be to your wealth, savings, and investments. Many who are planning for retirement seek advice from professionals for this very reason. At the end of the day, it is taxes that usually take the biggest chunk of your money, and you don’t get that money back – nor can you reinvest it.

That is, unless you incorporate tax-efficient investing into your wealth planning.

Strategies for Constructing a Tax-efficient Investment Portfolio

There are a handful of ways to build your portfolio to be “tax-smart.” Most of this revolves around your IRA and 401(k) and whether or not your accounts are taxable or not. In addition, you can utilize the strategies we’ve already mentioned and take capital loss tax offsets in your portfolio. Let’s look at a few of these strategies:

• Capital loss tax offset: the de facto way to cut costs from your portfolio when your tax burden for the year is heavy. Whatever taxable gains you have can be balanced by the losses in your losing investments.

• Diversification and asset allocation considerations: Often you’ll find that diversifying into treasury bonds, municipal bonds, and stock funds can mitigate some of the tax burdens you face. These assets are usually bought and sold less and will often carry tax-exempt status on state and local levels (bonds).
  
  

• The role of tax-advantaged and taxable investment accounts: Advantages come with limits. While typical accounts like a brokerage account are taxed, they don’t carry the limitations that a tax-exempt or tax-deferred account will. For example, a traditional IRA or 401(k) may provide you with a tax break up front, but you’ll be limited on the amount of contributions and withdrawals you can make from these accounts.

What is a Tax Loss Carryforward

Carrying forward a tax loss can be done when your capital losses exceed your capital gains in a fiscal year. These can be net operating losses for your business, stock portfolio, or other losses. The carryforward can then be claimed on future years, indefinitely, to offset a profit.

How to Carry Forward and Apply Tax Losses in Subsequent Years

When planning for year-end taxes, you or your accountant will designate whether or not you’ve incurred any losses for that year. These could be net operating losses (NOL) or capital loss carryforwards.

If determined that the advantage would be to carry forward either of these, there are proper procedures through the IRS. For NOL, it would simply be an NOL carryforward. The only drawback is that only 80% of the subsequent year’s income can be used for the offset in NOL carryforwards.

Strategic Planning for Long-term Tax Efficiency

Utilizing the IRS’s rules can benefit many investors who are aware. Not all businesses carry a profit each year. Many produce a negative net operating income (NOI), especially startups. To reduce the tax burden for these investors and startups, certain advantages like tax carryforwards, capital tax loss offsets, and other tax-efficient investment tools have been put in place to help reduce the tax burden in years when NOI becomes profitable.

Taxable Investment Accounts and Tax Loss Harvesting

As a wise investor, it is imperative to understand the impact of tax rules on different types of investment accounts. While most investors assume that a non-taxable account is better simply because it sounds great, there are advantages and disadvantages to both. For clarity, let’s take a look at some of the benefits of taxable investment accounts.

Tax Implications of Tax Loss Harvesting in Taxable Accounts

Taxable accounts are just as they sound — taxable. They don’t afford you the ability to forego taxes like a retirement account would. However, they do allow you to buy, sell, deposit, and withdraw funds at will. 

For many investors, the opportunity to make a profit without the limitations of a non-taxable account supercedes any need to avoid taxes. That being said, investors can still use taxable accounts to balance their tax implications each year.

Strategies for Managing Tax Liabilities in Taxable Accounts

Some of the best ways to manage your tax liability in a taxable account is to either hold your positions for more than a year or to re-balance your tax burden through tax-loss harvesting.

Taxable assets can qualify for a lower tax rate if held for more than a year. This is called long-term capital gains. Essentially, by holding the asset for more than a year, you forego the typical short-term capital gains tax rate, which is much higher.

However, if your portfolio is having a great year, you might find it beneficial to curate the tax burden before the end of the year by selling any losing positions in your portfolio. This allows you to offset the taxes you’ll incur from the positive gains on the year.

Smart Tax Planning

Long-term tax planning is a great way to maximize tax loss harvesting benefits. Whether you’re starting small or managing a large portfolio, anyone can take advantage of the built-in IRS tools for tax advantages.

Staying Compliant with Tax Laws and Regulations

Most traders who don’t fall under the Mark to Market status will file taxes like they would any other income or capital gains for the year. It’s imperative to document the trades you take and the receipts from those trades if you plan to claim a loss (simplified by most brokerages). 

You’ll then report your gains and losses on form 8949 and Schedule D of your tax return. This gives you the ability to claim up to $3000 in net capital losses each year.

Seeking Professional Guidance for Advanced Tax Strategies

As with any wealth planning or smart tax planning, it is always wise to consult the experts. However, many Main Street accountants are not well-versed in the rules and regulations for active traders. 

For active traders, we recommend reaching out to a trading-centric accounting firm like one of the three below:

• Traders Accounting
• Green’s Trader Tax
• Trader Tax CPA

While we don’t personally recommend any of the accounting services above, nor is this an exhaustive list, it’s an example of a few accounting services that deal specifically with accounting for traders. You may find more value with one of these providers to take advantage of smart tax planning as an investor.

Alternative Strategic Tax Planning Strategies

According to Ryan Puplava of Financial Sense Wealth Management, there are many choices you can make when putting your financial house in order. Many of these will depend on your marriage status and the age of your spouse. Ryan sends out these great tips in his newsletter. Here are a few unique tax strategies that he offers:

• Will unreimbursed medical expenses be high? If so, consider doing a Roth IRA conversion to take full advantage of the medical expense deduction.
• Is there a capital loss carryforward on your tax return attributable to the older spouse? If so, consider selling an asset at a gain to offset the carryforward loss. Carryforward losses can be used on the final tax return but will be lost thereafter if in the deceased spouse’s name.
• Are there any unrealized tax losses in an account owned by the older spouse? If so, consider harvesting the unrealized losses or consider gifting the asset to the younger spouse to preserve the loss and avoid the step-down in basis.

Conclusion

Smart investors can’t avoid the need for smart tax planning. As we’ve said before, taxes are more often than not the biggest burden on your portfolio every year. 

Taking advantage of tax loss harvesting techniques, maximizing your non-taxable accounts, and planning strategically with a knowledgeable accountant can help you keep as much of your hard-earned money as possible. 

If you’ve found this guide helpful, we hope you’ll share it with your friends. For more resources on how to trade and invest wisely, be sure to check out our blog for more fresh content. Also, be sure to read our Guide to Day Trading Taxes for more specific info on taxes for day traders!