Overview of Tax-loss Harvesting & Its Working Mechanism
People with taxable incomes are always looking for ways to curtail the taxes levied on their income. The market is full of potent methods by which this can be achieved. One such method is tax-loss harvesting. Many people worldwide use this very method to save their money and spend as little as possible on taxes.
Tax-loss harvesting is a tax-cutting technique wherein a person sells investments for a loss to reduce the capital gains tax, thus reducing their taxes. But this process is a rather complex one. It calls for immense practical knowledge and expertise. The financial market houses various investing techniques.
But building a portfolio of the necessary funds in the market can be complicated and challenging. These days, a significant chunk of the population is investing in mutual funds and exchange-traded funds. But getting to the core of such basic investment strategies also needs much homework.
The trade-loss harvesting method of investing is no exception. So, to judge this method’s effectiveness, one needs to have adequate knowledge about the same. So, let us dive into exploring the technicalities of tax-loss harvesting.
What is tax-loss harvesting?
Tax-loss harvesting is a complicated and advanced means of investing money. In this investing technique, a person sells their investments for a loss. Well, this loss is incurred to gain something in return. The profit attained here is in the form of benefits on tax reduction available for capital losses.
This method offsets the capital gains tax from selling profitable investment assets. Now, the question arises: what does one mean by compensating capital gains tax?
So, let us approach this first by exploring the capital gains tax. When a person sells an investment, the tax levied on the profit made on it is known as the capital gains tax. So, in tax-loss harvesting, the selling of investments at a loss to offset capital gains tax.
The working mechanism of tax-loss harvesting
The basic working mechanism of tax-loss harvesting involves selling an investment and investing it in another investment plan. Thus, this enables one to reduce taxes while staying in the market. In this process, a person incurs a loss and uses it to offset capital gains. This loss lessens the amount one spends in the form of capital gains tax incurred on profitable investments.
Significance of wash sale rule
When talking about tax-loss harvesting, one cannot rule out the wash sale rule. The wash sale rule prohibits one from selling an investment and then using the loss incurred to reduce taxes, followed by immediately purchasing that very investment. In simple words, it means that it restricts one from repurchasing any investment meant for tax-loss harvesting.
This rule applies when one tries to repurchase an investment that one sold for a loss within 30 days of selling it. In this case, the person is not eligible for getting any deduction on capital losses. So, the wash sale rule makes tax-loss harvesting complicated.
Who should go for tax-loss harvesting?
Tax-loss harvesting is an appealing method to save on taxes. It may seem extremely eye-catchy for taxpayers out there. But before jumping into executing this method, one needs to understand the risks and complexities involved in it.
It is too complicated a method to implement on a personal level. So, here comes the role of a professional to implement this tax reduction strategy. One can hire an investment manager to get the job done. Another major factor to keep in mind is that this method is for people who have significant investable assets.
So, this means that tax-loss harvesting is ideal for large taxpayers looking for ways to get rid of paying huge sums on taxes. It is also good for people who are not very much concerned about constructing a long-term investment portfolio for themselves. Individuals who have the appropriate knowledge and expertise about this method should go for it.
Benefits of tax-loss harvesting
• Offsets capital gains taxes
Tax-loss harvesting enables one to reduce taxes to a considerable extent. Its working mechanism is somewhat complicated, but when understood thoroughly, it has the potential to generate promising results.
In this investment strategy, a person sells an investment for a loss. This loss offsets or balances the tax levied on capital gains. The tax levied on capital gains is known as capital gains tax. Individuals with a promising investment portfolio can use this strategy to offset the money spent on capital gains tax.
• Reduces taxable income
People who fall under the tax bracket should make use of the tax-loss harvesting investment strategy. This investment strategy reduces the tax levied on capital gains incurred from profitable investments. It is complex in nature and involves the selling of investments running at a loss. The loss incurred directly reduces the tax on gains that a person makes through other investments.
In this way, the tax levied on a person’s income is reduced. So, people who are fed up of paying those extra bucks in the form of taxes can get hold of this strategy.
• Offers unlimited carry-over
Another beneficial aspect of the tax-loss harvesting method is that it allows one to have access to unlimited carry-over. Capital losses offset capital gains and up to USD 3,000 of a person’s regular income. This means that if a person incurs many losses in a given year, this loss can be carried forward to future tax years. This means one can reap tax benefits for many years as there is no limit to how long the losses can be carried forward.
Shortcomings of tax-loss harvesting
• Complicated process
Tax-loss harvesting is indeed a complicated process. There are a number of rules that one needs to cater to before using this investment strategy. The wash sale rule restricts one from selling and buying the same investment plan within 30 days. So, one needs to move one’s money to different investments while ensuring that one does not purchase the same investment again. These rules can be really complicated and hard to adhere to.
So, it may get tiresome to execute this strategy personally. One may need to hire an investment manager to carry out tax-loss harvesting.
• Benefits limited to taxable accounts
Tax-loss harvesting can be done only by people who have taxable incomes. This method is solely limited to reducing taxes. So, the people whose income does not come under the tax bracket are not benefited from it. In addition to this, people who invest in tax-advantaged accounts cannot use this investment strategy.
This is because retirement accounts are not subject to capital gains tax, meaning no tax is levied on these accounts. That tax-loss harvesting is not for everyone out there.
• Lowers cost basis
Tax-loss harvesting lowers the cost basis of the money saved in your investment portfolio. Losses generated from this strategy lead to an immediate tax reduction. But if one’s investments later appreciate, it will lead to more profit and more taxes to be paid.
• Mostly offers short-term gains
Another major shortcoming of tax-loss harvesting is that it offers short-term gains rather than long-term gains. The long-term capital gains tax rate is much higher than the short-term capital gains tax rate.
But to reap the benefits, one needs to maintain security for over a year. Frequent buying and selling of investments become a hurdle here. It becomes challenging to maintain security and thus leads to losses in the long term. One does get the benefits of short-term tax rebates, but in the long run, this investment strategy does not yield any long-term gains.
Conclusion
Tax-loss harvesting is one tax-saving method that must have crossed every taxpayer’s mind. Though appealing on the outside, it involves various layers. This complicated process is not everyone’s cup of tea.
It requires research and an understanding of how the market works. So, if you are a heavy taxpayer looking for a means to reduce the money spent on taxes, then tax-loss harvesting can come in handy for you. Tax-loss harvesting is terrific for people with significant investable assets.
