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As the saying goes, there are only two things in life that are certain: death and taxes. While we can’t determine how the first will unfold, it is possible to prevent Uncle Sam from taking all of your investment gains. One of the tried-and-true techniques for doing so is tax-loss harvesting. By selling your loss making investments, you can offset the gains in some of the winners; thereby, resulting in a lower tax bill.
The best part is that this could be an interesting time to do just that.
Thanks to potential tax changes and increases coming down the pike, now could be a great time to use tax-loss harvesting and offset potential bigger taxes throughout the year. For investors, it’s one of the few free gifts the market offers.
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One way to think of tax-loss harvesting is like a rose bush. To spur new growth and improve the overall health of the plant, we simply cut off dead or dying branches. Your portfolio functions in much the same way. All of your assets can be thought of as the rose bush – cutting off dead weight can do wonders for its long-term performance. And that’s where tax-loss harvesting comes in.
Essentially, tax-loss harvesting involves selling the stocks, funds or assets that are currently showing a “paper” loss in your portfolio. This turns them into a “realized” loss. Most investors don’t particularly want to sell a stock at a loss, but it can actually be beneficial.
This is because the IRS lets you use those losses to offset realized gains in other securities. So, if you sold shares of a small-cap biotech stock at a $1,000 loss, you could use that to offset a $1,000 gain in your Google shares. Better still is that the IRS will let you use these losses to reduce ordinary income in a year. If your capital losses exceed your capital gains or if you have none in a year, $3,000 worth of those losses can be used to reduce your ordinary income. And if you lose more than $3,000 on a stock, the excess can be pushed into the future to offset capital gains and ordinary income later on.
This pruning of a portfolio helps to boost overall returns. According to a study by economists at MIT and Chapman University, tax-loss harvesting produced an extra 1.10% in return per year from 1926 to 2018. That’s a pretty significant boost when factoring in compounding of returns.
With the start of the year, investors have an interesting opportunity to tax-loss harvest and prune their portfolios.
There’s a good chance that investors are already sitting on some large long- and short-term gains. Overall, the S&P 500 increased by 26.9% in 2021. This follows a nearly 19% gain in 2020. That’s very good performance for the market. And investors may want to hold onto some of those gains.
For one thing, market expectations for 2022 are pretty muted, with some analysts calling for low single-digit gains on the index.
But it comes particularly important when considering recent spending plans. The recent spending plans by the Biden administration for infrastructure, pandemic relief and other social programs are expected to raise overall taxes. In order to pay for the plans, Democrats and the Biden administration have proposed everything from taxing stock buybacks and dividends to raising ordinary income rates and capital gains taxes. This can potentially be a nightmare scenario for investors.
However, aside from the infrastructure plan, many of the wide-sweeping social program bills have been sent back to the drawing board due to opposition.
This gives investors a bit more time to prune their portfolios of last year’s losers and get ahead of potential tax increases in the new year. Even if you don’t harvest any gains or sell any winning stocks in 2022, the reduction in ordinary income from selling losers could be very valuable. This is especially true considering market return expectations in 2022 are low. Secondly, carrying over any investment losses further – into 2023, 2024, etc. – could be very valuable considering any tax changes. This allows investors to be proactive with their future changes to tax laws.
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All in all, tax-loss harvesting is a great technique to boost returns and reduce taxes. Right now, investors have an extra chance to get ahead of any potential tax policy changes for the year and lock in a great way to reduce what they owe Uncle Sam going forward. Even if investors don’t sell any winners in the new year, the ability to reduce ordinary income rates and carry forward losses is very valuable given the uncertainty with tax policies. Locking in ways to reduce taxes now makes a ton of sense.
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