Tax Loss Harvesting - Making Lemonade Out of Lemons

Has the volatility of the stock market got you thinking about what to do? Now may be the right time to make your own lemonade stand. Consider doing some tax loss harvesting.

So how does this work? Selling securities at a loss can offset your capital gains tax liability. At the end of the year, your capital gains and losses get netted against one another. Your short term gains are taxed at your ordinary income tax rate. In most cases, long term gains are taxed at 15%. In any year, there is no limit to the amount of losses that can be taken to offset realized gains. You also can deduct $3000 of realized losses against your ordinary income. Any remaining losses can be carried forward into future tax years indefinitely. These tax loss carry forwards can be used to either reduce future capital gains or $3000 of your ordinary income each year.

This process doesn't have to be done at year end. You can do this at any point during the year. You may have losses that you can take at the beginning of the year, which may not be available at the end of the year. A few things to consider: be careful of the IRS Wash Sale Rule. This states that you can not sell a security and buy the same identical one back within 30 days. If you do this, you will not be able to use the loss for tax purposes. Additionally, you can not use any realized losses in retirement plans or IRAs to offset gains in taxable accounts.

Tax loss harvesting is usually easier to do with mutual funds and ETFs (Exchanged Traded Funds) versus individual stocks. Here are a few examples: you can sell Fidelity Select Health Care (FSPHX) and buy the Vanguard Health Care Fund (VGHCX), maintain similar exposure, and not have to wait 30 days, and take the loss. You can sell SPY (S&P 500 index) and buy IYY (Dow Jones U.S. Index Fund). It is recommended by tax professionals that you do not sell one index fund and buy the same index fund offered by another fund company. It's better to buy a different index with the proceeds.

If done right, tax loss harvesting can reduce your tax liability and come close to maintaining your portfolio's original structure.

This article is for informational purposes only and should not be construed as individualized investment advice.