Tax-loss harvesting a strategy

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Tax-loss harvesting a strategy
Tax-loss harvesting is a strategy that can help investors minimize any taxes they may owe on capital gains or their regular income.
Sometimes an investment that has lost value can still help your portfolio; if an investment drops you can deduct that loss, which can also help boost your total investment returns.
For a married couple filing jointly, up to $3,000 per year in realized capital losses can be used to offset capital gains tax or taxes owed on ordinary income.
The IRS bans investors from deducting a capital loss on the sale of a security against the capital gain of the same security; This is called a wash sale.
A general rule is that you should only harvest the loss if the tax benefit outweighs the administrative cost.
Understanding Tax-Loss Harvesting

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An investment loss can be used to offset capital gains tax on realized gains in an investment portfolio; it can also be used to offset taxes on ordinary income. For a married couple filing jointly, up to $3,000 per year in realized losses can be used to offset ordinary income on federal income taxes.1

Even if an investor doesn't anticipate any capital gains this year, there are still benefits to the tax-loss harvesting strategy because capital losses can be used to offset ordinary income. In addition, losses can also be carried into the future indefinitely and used to offset future gains.

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Capital Loss
Sometimes an investment that has lost value can still help your portfolio. If an investment drops, you can deduct that loss, which can also help boost your total investment returns. For example, suppose an individual invests $10,000 in an exchange traded fund (ETF) at the beginning of the year. Then this ETF decreases in value by 10% and drops to a market value of $9,000. This is considered a capital loss of $1,000.

A capital loss occurs anytime an asset decreases in value. However, a loss is not considered realized for tax purposes until the investment has been sold for a price lower than the original purchase price.
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Suppose that the market reverses course and this investment closes out the year at $10,800. Pre-tax, this represents a 10% return (after adding in the typical 2% dividend yield). Assuming this investor is in the highest tax bracket, their after-tax return is 9.4%, which accounts for an approximately 8% gain, plus a dividend gain of approximately 1.4%.
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However, if this investor had decided to sell the investment immediately following the initial drop in price and purchased additional shares with the proceeds, they would be able to use this realized loss of $1,000 to offset either taxable capital gains they were reporting or taxes on their ordinary income. At the top tax rate, this could potentially save them $760 in income taxes. This would also add an additional 7.6% return to their original $10,000 investment.

Using tax-loss harvesting, this investor's net after-tax return on their investment would now be approximately 16.6%, or equal to 9% plus 7.6%.
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Limitations to Tax-Loss Harvesting
There are certain limitations to the effectiveness of this strategy, in addition to regulations put in place by the Internal Revenue Service (IRS).

Wash-Sale Rule
Investors cannot deduct a capital loss on the sale of a security against the capital gain of the same security. This is called a wash sale. Wash-sale rules prevent taxpayers from selling or trading a security at a loss and, within 30 days before or after this sale, buying the same stock or security—or a “substantially identical” one (or acquiring a contract or an option to do so). In the event of a wash sale, your tax write-off may be disallowed by the IRS.2

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For investors that want to harvest their losses, while also avoiding any wash-rule violations, one strategy for an individual stock that loses value is to replace it with a mutual fund or an exchange-traded fund (ETF) that targets the same industry. This will allow you to maintain a similar asset allocation in your portfolio.

Tax Liability Threshold
Up to $3,000 of realized capital loss can be used to reduce your taxable income in one year (if an investor uses the tax-filing status married filing jointly). An individual can deduct up to $1,500 in one year. Any additional loss can be carried forward for use on future tax returns.3
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Administrative Costs
Completing a transaction every time the market goes down can be onerous from a tax-preparation standpoint. A general rule is that you should only harvest the loss if the tax benefit outweighs the administrative cost.
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The Bottom Line
Tax laws create the opportunity to engage in tax-loss harvesting as an investment strategy. However, tax savings should never lessen or stand in the way of your investing goals. In some cases, your after-tax returns can be boosted by this strategy, resulting in quicker asset accumulation.

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