By Lee Sherman
Newbie investors can be spooked by the ups and downs of the market but if following the performance of your investments is making you a bit seasick, here’s an anchor you can grab onto.
Tax-Loss Harvesting is the practice of selling an underproducing asset and replacing it with a similar one that allows you to maintain your optimal asset allocation. It’s possible to offset your capital gains with capital losses to reduce your tax burden (and as we’ll see below, maybe even turn a profit).
If you have more capital losses than gains in a year, you can use a $3,000 credit to offset your income while the remainder carries over into future years if unused. Tax-Loss Harvesting doesn’t eliminate taxes, it merely defers them. However, unlike with casino gambling, where once the money is gone, it’s gone, Tax-Loss Harvesting does allow you to recoup any losses.
No Second Chances?
It works like this. If the value of one of your assets such as an exchange-traded fund (ETF) declines, you’d normally suffer a loss. That loss can reduce your tax burden but it also means that you’d need to invest more money in order to maintain your current exposure. What if, instead, you sold this poor-performing ETF and reinvested the money in another vehicle? There’s a (fairly good chance) this new fund could outperform the one you initially invested in and turn things around. If that happens, you’ve not only avoided the loss but might even get a return on your investment. Who says there are no second chances in investing? If it sounds like a fairly aggressive strategy it is. But the good news is that it can be automated. There is even software available for this.
Understanding Capital Gains
You’ll need to pay federal capital gains tax whenever you sell an asset for a profit. Short-term gains are taxed on investments held less than a year and are taxed at ordinary income tax rates, topping out at 39.6%. Long-term capital gains tax applies for any investments held longer than one year. As of 2015, the rate is set at 0%, 15% or 20%, based on the individual investor’s tax bracket. The math gets more complex from here so seek out the advice of a financial planner.
Skies are gray
Something called the wash-sale rule requires that investors wait 30 days before a sale and 30 days after it is complete to replace a “substantially identical” asset. Unfortunately, the IRS has failed to provide strict guidelines on what constitutes a similar enough stock. This is another gray area that is best navigated with the help of a financial planner. That said when deciding whether Tax-Loss Harvesting can serve as your umbrella on a rainy day, consider that any transaction fees may eat up any potential gains. So, while Tax-Loss Harvesting can be a good way to make your money work harder for you, you’ll want to make sure you are tracking with a market index like the S&P 500 if you decide to automate this process.
Lee Sherman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Lee is an experienced journalist and editor with over 30 years of expertise with a significant history of writing in the personal finance and technology arenas.