As an investor, the new year has reminded us of the sometimes difficult feelings that come with a down market. Reminding ourselves of the normality of market fluctuation can be unpleasant, but it is one of the many times we must remain diligent and patient as an investor. While no one loves to see a dip in the market, there are many ways that we can make the most of a market correction. Tax loss harvesting is one way that we help our clients uncover the silver lining of a down market.
What is tax loss harvesting?
Tax loss harvesting is the process of selling a security when the market is down. This strategy allows you to capture a loss that can be used to save money on your taxes. It is important to note that this tactic is only necessary for taxable accounts and not Individual Retirement Accounts (IRAs).
Traditional IRAs already have a tax-deferred status. This means that the account grows, free of taxes, until you begin pulling funds out of it after age 59.5. At this point, you begin to pay taxes on the portion of the funds that you remove from the Traditional IRA. Furthermore, Roth IRAs have a tax-free status. This means that your Roth IRA grows free of taxes, assuming you wait to distribute funds until you are at least age 59.5. Due to the tax status of both Traditional and Roth IRAs, there is no need for tax loss harvesting in these types of accounts.
How does tax loss harvesting work?
Without getting too far into the weeds, tax loss harvesting involves swapping out a security in your portfolio with another similar security. This allows you to stay in the market and experience any upticks. Most importantly, it allows you to capture the loss which can be used against future capital gains.
What is a capital gain?
When you sell an investment asset for a profit in a taxable account, you owe capital gains taxes on the profits. The amount you owe in taxes is dependent on how long you held the investment. If you held the investment for less than one year, you would pay your normal income tax rate on any gains. If you held the investment for longer than one year, you would owe the long-term capital gains rate. The long-term capital gains rate is typically favored over your ordinary income tax rate. Your long-term capital gain tax rate is dependent on your income but ranges from 0% to 20%.
You might be asking yourself, “What if I don’t have any capital gains to offset?” Even if you do not plan on having any capital gains to offset, you can use the harvested loss to offset ordinary income. It is important to note that there is a cap of $3,000 worth of losses that can be used to offset ordinary income each year.
How do I know if my advisor is utilizing tax loss harvesting?
If you are a Pearl Planning client, you can rest assured that your account is being reviewed daily for tax-loss harvesting opportunities. This is a fundamental part of our investing process for each of our clients with taxable accounts.
If you are not a Pearl Planning client, consider checking with your advisor to see if they are making the most of tax loss harvesting opportunities. If not, you are always welcome to schedule a call with us to see how we can assist in making your portfolio and investment process more tax efficient.
At Pearl Planning, we believe that tax planning is a critical component of your financial plan. Feel free to check out our webinar on Tax Aware Investment Strategies. In this webinar, Pearl Planning president and financial advisor Melissa Joy, CFP®, CDFA®, provides even more information on how we incorporate taxes into your financial planning strategy.
As always, if you have any questions or if you would like to discuss tax planning in more detail, please do not hesitate to give us a call.
Investment advisory services offered by Pearl Planning, a DBA of Stephens Consulting LLC., an SEC registered investment adviser. Please remember that past performance may not be indicative of future results. Pearl Planning does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results.
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Hannah Near, CFP®, CPA is a financial advisor at Pearl Planning. Reach out for a call today at 734.274.6744.