Give Yourself a Last-Minute Tax Refund Boost Using This Strategy

There are only a few trading days left in the year. With the clock winding down on 2020, you may be limited in how much you can reposition your investments to get an increase in your overall rate of return.

But there are other actions that you can still take, like tax-loss harvesting, that can help you put more money in your pocket. When you use this strategy you can offset tax liabilities created from your investments by selling some of your holdings at a loss. Here’s how. 

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How tax-loss harvesting works

With your non-retirement accounts, you’ll usually owe taxes when you sell your holdings for more than you bought them for. For instance, if you sell an investment for $8,000 that you bought for $5,000, you have $3,000 worth of capital gains. In a taxable account, you could also owe taxes on any income that has been paid out to your account, like a dividend or capital gains distribution. When you deduct the amount of money you’ve paid in taxes from your total gains, your overall investment return is lowered. 

Proceeds from sales of investments that you’ve held for longer than a year and qualified dividends get taxed at a long-term capital gains rate that ranges from 0% to 20%. If you’ve held a security for a year or less when you sell it or receive nonqualified dividends, you’ll owe taxes based on your marginal income tax bracket. That rate will range between 10% and 37%.

You can offset your short-term losses against short-term gains and your long-term losses against your long-term gains. If after doing this, you have any losses remaining in either of these categories, you can then use them to offset your gains in the other category.

For example, if you have $10,000 worth of long-term losses, $5,000 worth of long-term gains, and $2,000 worth of short-term gains, you will first offset the $5,000 worth of long-term gains. You can then use the remaining $5,000 in losses to offset the $2,000 worth of short-term gains.

After doing this, if you still have losses remaining, you can then use up to $3,000 in losses each year to offset other types of taxable income, such as wages. The limit is $1,500 if you are married and filing separately. If you have more losses than that, you can carry any losses that are unused forward indefinitely and use them to offset gains in future years. 

Pitfalls of tax-loss harvesting

Tax-loss harvesting doesn’t always go well. There are some investments that you may have bought that are trading at a loss and are no longer good investments, but others may currently be trading at a loss but still have growth potential. If you sell this latter type of holding this year so that you can harvest the loss and then that investment recoups its losses and grows substantially, you might miss out.  

If you’re thinking that you can remedy this problem by immediately buying the investment back after selling it, it’s not that easy. Under the wash-sale rule, you can’t claim a tax loss if you sell a security and then buy it or a substantially identical security immediately. Instead, you must let 30 days must pass before repurchasing the holding. It’s possible that the security will be trading at the same price or lower 30 days from when you sell it, but if it’s moved up in price significantly, you’ll be buying it at a higher price than you sold it for. 

What securities should you sell?

So what should you sell? There may be a security that you own that’s losing money and that you’ve fallen out of love with. But you fear that it will make a comeback after you sell it, so you’re hesitant. Deciding that you will use it for this purpose may help quiet those fears and help you take action.

When you rebalance, there may be an asset class that you own too much of. Some of the individual positions you own inside of these investment classes may be trading at a loss. If they are, you can consider selling them and accomplish your rebalancing and tax-loss harvesting needs at the same time. 

Every dollar counts, and you don’t want taxes eating away at your investment return. When the pros of tax-loss harvesting outweigh the cons, it can help you reduce your tax bill. Doing this means that less of your money goes to Uncle Sam and more goes toward meeting your investing goal.