What Is Tax Loss Collection (and Who Benefits From It)?
If you notice underperforming investments in your portfolio, you may have a silver lining: tax loss collection. This strategy allows taxable capital gains to be offset by capital losses. Through this process, you can reduce your tax bill and improve your overall portfolio going forward. We’ve covered this topic before when we talked about cryptocurrencies , but here’s what you need to know about tax loss collection for the typical investor.
What is tax loss collection?
Tax loss collection is a method of selling certain investments at a loss in order to reduce the amount of taxes paid. By strategically absorbing this capital loss, you can offset the taxes owed on your capital gains, such as your investments that were sold at a profit. At the same time, you can replace underperforming investments with similar ones to better position your portfolio.
What is the advantage of collecting tax losses?
Whenever you sell an investment for profit, you will be subject to capital gains tax accordingly. And when you cash out an investment, that tax can get huge—up to 37% if you sell within a year. However, the recorded loss associated with the collection of tax losses offsets these gains. Remember: the advantage here is to defer taxes, not to eliminate them.
In addition to reducing taxes owed, another idea for collecting tax losses is that you use the freed up cash to buy new assets to replace investments you sold at a loss. These new assets will likely be similar to those you sold, so your asset allocation and risk profile will remain largely the same. Ideally, you will be able to rebalance your portfolio to achieve better results without radically changing your overall investment goals and strategies.
According to Fidelity , the goal of collecting tax losses is to have less of your money going into taxes and more money to stay invested and work for you.
Is collecting tax losses right for you?
According to Forbes , even taxpayers who don’t report capital gains can benefit from this method, as investment losses can also be used to reclaim taxes on your ordinary income. However, as with all taxes, there are many things to consider carefully before you dive headlong into collecting tax losses yourself.
First, the collection of tax losses is relevant only for taxable investment accounts, not for tax-deferred retirement accounts such as 401(k) or IRA. Sold investments can be any tradable securities: stocks, bonds or even cryptocurrencies.
While you don’t need a huge capital gain to practice tax loss collection, this strategy is mostly relevant for investors in higher tax brackets. The higher your income, the more money you will save by reducing your taxable income; plus, the more money you make, the more likely you are to mess around with your invested assets. On the other hand, anyone earning less than $40,000 as a single member or $80,000 as a joint member owes nothing on their long-term capital gains; the collection of tax losses is irrelevant to them.
Here is the information from the IRS for reporting capital gains and losses. Charles Schwab also provides a helpful explanation of how you can use the tax loss collection with ordinary income.
What else you need to know before trying to collect tax losses
Trying to harvest can do more harm than good. Forbes explains that you should not prioritize collecting tax losses over your main investment strategy or goals. This method should also only be used when you can “immediately reinvest in a suitable (but not identical) replacement that retains the overall strategy.”
There are rules and restrictions to be aware of when navigating through this kind of transaction. First of all, be aware of the sham sell rule , which prevents you from selling a stock at a loss and then re-buying the same (or “virtually identical”) stock within 30 days.
After all, if you are not a tax expert yourself, you should consider enlisting his help. No matter what, you will need to keep a good record of your transactions in case you ever face the wrath of the IRS in the future. And if you don’t want to invest in working with a tax professional, you can always consider robotic advisors .