Practical Money: Turn market losses in tax savings! Year-end tax strategies
A look at ways to save money on your 2023 tax returns.
Introduction
It’s the end of the year, and tax season is just around the corner. Luckily there are still a few weeks to make last-minute moves to save money on taxes.
There are always a host of items to consider as the year ends. Some of those include:
Maximizing your 401K. If you have a 401K or other employer-sponsored account, you generally have until the end of the year to make your final contributions. Usually, you have to contact your employer if you want to change your contribution amount to reach your limit.
Contributions to an HSA account, ROTH, or Traditional IRA. You have until April 15th to make those contributions for 2023.
Changes are coming to 401K and IRA plans next year, you can read about those here.
Other considerations include ROTH conversions, RMDs for retirees, flexible spending accounts, charitable contributions, 529 contributions, and 529 withdrawals. It’s always a good time to contact a financial professional to make sure you’re taking advantage of the tax benefits available. There is also tax loss harvesting, which is a strategy to sell investments that have lost money to reduce the amount of money you'll owe on your taxes. I will discuss how I use it below.
A quick reminder that this is not financial advice, just myself sharing my investments, stocks, index fund strategies, what I'm buying, and where I plan to take those investments. Everyone’s financial goals are different. No financial decisions should be made solely on this newsletter, which is for informational and entertainment purposes only and is not intended to be a substitute for advice from a professional financial advisor or qualified expert.
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Tax Loss Harvesting Explained
Tax-loss harvesting is a strategy to sell investments that have lost money to reduce the amount of money you'll owe for income taxes. It’s a strategy that a lot of investors utilize at the end of each year. There have been studies showing that tax loss harvesting yielded almost an additional 1% annual return each year from 1928 to 2018.
Ideally, you want to buy low and sell high. However, I’ve had times when I’ve had investments that are losers, that I don’t see being good investments in the future. Here are some examples of tax loss harvesting by selling securities at a loss:
Example 1: Let’s say you bought $10,000 in Exxon and today it’s worth $15,000. If you sold the stock, you would have to pay capital gains taxes on the $5,000 profit.
Now let’s say you had bought $10,000 in GM stock and today it’s worth $5,000. If you sold it, that $5,000 loss on your GM stock would offset the taxes on the $5,000 in profit from the sale of your Exxon stock entirely.
If your losses are greater than your profits, the IRS allows you another $3,000 deduction of the remaining loss to lower your ordinary taxable income. Anything over that can be rolled over into future years. That might sound complicated, so here’s another example.
Example 2: Keeping with the original example, let’s say you bought $10,000 in Exxon and today it’s worth $15,000. If you sold the stock, you would have to pay capital gains taxes on the $5,000 profit.
Now let’s say you had bought $20,000 in GM stock and today it’s worth $10,000, so you sell it at a loss of $10,000. $5,000 of that loss will offset the taxes from the $5,000 in profits from the Exxon sale. You’re still left with $5,000 in losses. You can then use $3,000 from those losses to lower your ordinary taxable income for this year and roll over the remaining $2,000 for a future year.
Basically in this last example, you received $8,000 in tax benefits this year, and another $2,000 down the road to offset future gains.
The Wash Rule
The IRS has a wash sale rule, which means you can’t sell a position and take the loss on your taxes, and then buy the same or substantially similar position 30 days before or after the sale. For instance, you can’t take sell an S&P 500 index fund like IVV at a loss on your taxes, and then right away buy another S&P 500 index fund like VOO.
So in this example, you can’t just sell your GM stock, sell it at a loss for your taxes, and then buy more GM stock, at least for 31 days. But you can buy another automotive stock like Ford or Volkswagen. So you get the tax benefit from the loss of your GM stock, but you still stay invested in the auto industry.
Saving Taxes On Your Gains
If you have losses on a security, you can sell other securities at a gain and then immediately repurchase them since the 30-day wash sale rule does not apply to gains. By doing this, your gain is tax-free while you retain your original investment, and you will have a higher cost basis for the new investment.
Going back to the example above, let’s say I had that Exxon stock that I purchased at $10,000 that is now worth $15,000. And let’s say I have GM stock that I purchased at $20,000 that is now worth $15,000. If I sell both, the $5,000 loss on GM stock cancels out the $5,000 gain with Exxon. I can then go and immediately purchase back the Exxon stock, and the cost basis for it is now higher. I still have the same amount of Exxon stock, but I owe $0 in taxes for that gain.
Things To Keep In Mind
A couple of things to keep in mind. Tax-loss harvesting can only be done in taxable accounts (so not in IRAs, 401Ks, etc.).
Things can get a little tricky with short-term vs. long-term assets. With stocks, ETFs, and mutual funds, assets that have been held for less than a year are short-term, while long-term assets are those that have been held for longer than a year. Short-term losses offset short-term gains, and long-term losses offset long-term gains. Excess losses in either can be applied to either type of gain. So short-term losses will first offset short-term gains, and if you still have more short-term losses, it will then be applied to long-term gains.
Short-term gains may be subject to ordinary tax rates (which are generally higher than capital gains), so it might be worthwhile to realize a long-term loss to absorb this short-term capital gain.
How I’m Using Tax Loss Harvesting This Year
I received the second payment from the sale of WrestlingInc.com this year so I’m using tax loss harvesting to offset some of that gain.
Since I already have that gain, I’m not looking to sell any stocks, mutual funds, or ETFs that have had a gain this year. However, I do have two stocks that I purchased over a year ago that are down: 1) Exxon (XOM) which is down 8%, and 2) Reality Income Corp (O) which is down 14%.
In the case of Exxon, I’m going to sell my entire position in the next week or two, and use that loss to offset my gains from the payment from the sale. I will then either buy EOG Resources (EOG), which is another energy stock that was recommended to me by a friend, so I’m still equally weighted in the energy sector. Or I might re-purchase Exxon after 30 days.
For Reality Income, it is a REIT, and most REITs have gotten hammered this year. Like with Exxon, I’m going to sell my entire position shortly. I might use the funds from that sale to either purchase more shares of an existing REIT that I own - Starwood Property Trust (STWD) - or, I more likely will just wait 31 days and buy back into Reality Income.
Conclusion
I know reading this can get complicated and make your head spin a bit. Below are some helpful links with more information:
As always, no financial decisions should be made solely on this newsletter, which is for informational and entertainment purposes only and is not intended to be a substitute for advice from a professional financial advisor or qualified expert.
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