Many advisors are overlooking a key way to use investment losses to an investor’s advantage: tax loss harvesting.
While no one wants to lose money on an investment, these losses can potentially be used to help reduce one’s tax bill. The process of selling underperforming investments and using the losses to offset gains from other investments and/or ordinary income is referred to as “tax loss harvesting,” according to Invesco.
In a hypothetical example of how the tax loss harvesting process works, an investor will sell the underperforming investments at a loss. The investor then uses capital losses to offset capital gains and/or ordinary income. If losses exceed gains or there are only losses incurred, up to $3,000 can be used to offset ordinary income in the current year. Any amount above $3,000 can be carried forward for use in future years.
The final step is replacing the investment, either to maintain one’s existing asset allocation or invest in a new area. By selling an underperforming investment, there is now cash on the table to invest in something else.
However, if you sell a security and harvest a tax loss on that sale, the Internal Revenue Service’s (IRS) guidelines commonly referred to as the “wash sale” rule will come into play.
The wash sale rule outlines that investors cannot buy a “substantially identical” security 30 days before or after the sale of the funds chosen when conducting tax loss harvesting. This doesn’t mean the investor has to buy an investment in a completely different industry. For example, if an investor sold a tech company stock to harvest a tax loss — but still wants tech exposure — they could potentially buy a new or different ETF, mutual fund, or security within a similar industry, according to Invesco.
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