Few things can be as frustrating as spending months carefully assembling an investment thesis for a stock, finally getting a chance to buy at a price you like and then watching every single part of your carefully laid plan immediately go to pieces. But, that bit of breaking news that the CFO is headed to prison for lying about earnings for years or whatever did damage to the stock doesn’t have to all be bad, depending on your financial situation. In fact, for some investors, a decline for some piece of their portfolio could present them with the opportunity to create some major savings come tax time. So, if you’ve never heard the term “tax-loss harvesting” before, it might be time to get acquainted. It’s one way that you can help turn the pain of a falling stock market into a way to ease that other pain you start feeling around April every year.
What Is Tax-Loss Harvesting?
When it comes to selling stocks at a loss, the important thing to understand is that any losses in your portfolio can be used to offset taxes on stock gains. Understanding that aspect of the tax code is the root of a strategy known as tax-loss harvesting — identifying losing stocks and selling them to reduce your tax liability.
So, say you’ve sold stock in Company A for a $10,000 profit earlier in the year. Now, it’s December and you’re starting to think it’s time to cut bait on your losing investment in Company B that’s down $5,000 from where you bought it. By selling stock in Company B and realizing the $5,000 loss, your taxable capital gains from the previous successful sale — and the corresponding tax bill — would be cut in half.
And while you’re certainly missing out if Company B manages to buck its downtrend, it’s important to note that you’ll also be getting a chance to reinvest that money you currently have in a losing stock. So, you might be able to score both the tax benefits of realizing a capital loss and the improved returns from your portfolio from trading a losing stock for a winner.
Understanding Capital Loss Carryover and How It Might Apply to You
The tax benefits of selling a losing stock aren’t limited to the year in which you make the sale or to those people who have capital gains to reduce elsewhere. In fact, using capital loss carryover rules, you might be able to turn a big loss in the stock market into years of tax benefits with or without any corresponding capital gains.
The two things to understand are that you can claim a deduction of up to $3,000 per tax year for capital losses even if you don’t have corresponding capital gains, and any capital losses that don’t fit under that $3,000 cap can be carried over to future years. That means a large capital loss — while not ideal — could mean a deduction you can keep applying year after year.
That does come with certain limitations, though. For starters, if it’s a long-term capital loss, you have to apply your deduction to long-term capital gains — which are almost always taxed at a lower rate — prior to using them to offset any short-term capital gains. You also can’t pick and choose when you use those losses — you’ll have to use them to offset a future capital gain even if you might benefit from holding off. And finally, there are certain “wash sale” rules to prevent you from selling an investment for a loss to claim the capital losses but buying back into that same investment — i.e., you can’t game the system by selling an investment and then immediately buying back in.
Tax Benefits Don’t Make Up for Bad Investing, but Knowing Tax Law Can Present New Options
This should go without saying, but while there are some significant tax benefits to selling a stock at a loss, you should still always invest with the goal of not losing money. If you start selling off any stock that dips into the red, you could also be costing yourself way more in future returns than you could ever make back from writing off your capital losses. After all, if you had sold stock in Amazon or Apple a decade ago just because it dipped right after you bought it and you thought that was a great way to save a few hundred dollars on your tax bill, well, you probably don’t need any help understanding how that wound up being a really poor choice.
Any time you’re considering selling a losing stock to save on taxes, return to your original investment thesis and determine if something major has changed. If nothing else, take some time to review why you decided to buy at first. It’s a chance to dig into your thought process and potentially make improvements that will help you avoid picking losing stock again in the future, if nothing else.
However, the value of a capital loss on your taxes might be something to include in certain future investing decisions. In particular, if there’s a chance for a high-risk, high-reward investment where you’re probably going to take a loss but would reap huge gains if things do break right, potential future tax deductions could be part of your calculus on whether or not it’s worth taking a chance.
Click through to read more about simple ways to tell when it’s time to sell a stock.
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