Saving taxes in a bad stock market
December 21, 2018 | By Kevin Smith
There are two great things about bad stock markets: 1) opportunities to buy at attractive prices, and 2) opportunities to harvest tax losses. We have been hard at work over the last couple of weeks finding ways to save our clients on taxes for 2018 using a technique called Tax Loss Harvesting, which uses losses to offset gains.
Capital gains and losses are created by the funds you own when they sell stocks on your behalf. The resulting tax liability is passed on to you. The gains have been unusually high in large part because of the ten year bull market run, which means most sales resulted in gains. The best way to understand Tax Loss Harvesting is with an example:
Let’s pretend your 2018 year-to-date capital gains are $10,000. This means you will pay a 15% tax rate and owe $1,500 to the IRS when you file your tax return.
Tax Loss Harvesting works like this…
Let’s pretend you bought $50,000 of the US Stock Market Fund mutual fund a year ago. Now that fund is valued at $42,500 because of a 15% decline in the US stock market.
- If we sell 100% of that fund, you will incur a $7,500 capital loss which will reduce your $10,000 capital gain to $2,500, reducing your tax liability from $1,500 to $375. That is a $1,125 tax savings.
- We reinvest the $42,500 in a low cost Exchange Traded Funds (ETF) that has very similar risk and return expectations. This keeps you invested.
- After 30 days, we have the option to move back into the original investment without triggering the Wash Sale Rule, which would nullify the tax savings.
The desired effect is to reduce capital gains taxes while remaining invested in such a way that your returns will not be much different than they would have been if you did not use this strategy.
Notes: this is only useful for non-retirement accounts because 401(k)s, IRAs and Roth IRAs do not incur capital gains taxes. It is also important to pay careful attention to transactions costs required for execution.
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