What is Tax Loss Harvesting?
Posted on . 3 min read
Save some income tax by tax loss harvesting before end of the year. In 10 minutes, learn how to save taxes on investment gains.
What exactly is tax loss harvesting?
🕵️♀️ Sell one investment for a loss to offset gains you have from other investments.
How does it work?
1️⃣ In your brokerage account, look for “realized gains” for the year to know how much gains you need/want to offset.
2️⃣ Say you sold some investments (stocks, index funds etc) earlier in the year that resulted in $20k profit/gains. These gains will be taxed at 15%-20% if you held the underlying investment for longer than one year (long term capital gains tax rate). If investments were held for less than one year, the short term gains are taxed at regular (higher) income tax rate. 📈
3️⃣ Let’s say you also have some S&P 500 (SPY) ETFs that are currently underwater. 📉
4️⃣ You can sell SPY to take the $20k loss, enough to offset gains.
5️⃣ Then buy a similar (but not the same) investment (say Nasdaq 100 QQQ ETF) with the money from the SPY sale.
6️⃣ Why QQQ? Because QQQ & SPY have 98% similarity in stock prices over the last five years. This means that you can reduce your tax liability today without giving up the potential gains in the future.
7️⃣ You can apply the same principle to highly correlated stocks or between some stocks and ETFs:
Mastercard (MA) <> Visa (V) - 99% correlation
Square/Block (SQ) <> Ark Invest ETF (ARKK) - 97% correlation
Meta (META) <> Snap (SNAP) - 90% correlation
United Airlines (UAL) <> American Airlines (AAL) - 75% correlation
🙅Wash Sale 🙅:
Important to note that if you buy SPY within 30 calendar days of selling SPY for a loss, then this loss will be ineligible to offset profits. Say you sell SNAP on Nov 25th, 2022 for $10k loss. If you bought even a single share of SNAP between Oct 25th and Dec 25th, your sale will be considered a “wash sale” and you will not be able to offset any profits with it. Buying a similar, but not the same, investment is the key to getting this tax advantage to work for you. Wash sale rule applies across accounts: if you sell SNAP in the brokerage account and buy it in the 401k account within 30 days, the loss would be a wash sale.
🤑 This is only applicable to regular brokerage accounts. Any losses or gains in 401k, roth 401k, IRA etc accounts do not have tax implications when you buy or sell any investments.
DISCLAIMER: For more on IRS allowances for capital gains and capital losses, please see the IRS website or consult your personal tax advisor.