Tax-loss harvesting, or selling investments such as stocks, bonds, and mutual funds that have lost value, can reduce the tax liability on capital gains realized from winning investments.
You want to do this every year to keep your asset allocation in the same target that you want. For instance, if you target 65% in stock mutual funds and that amount has grown to 75%, then you can offset the 10% of those gains with other losses in your portfolio so you don’t pay any tax and you keep diversified. You also stay on target with your asset allocation.
Capital gains and losses are classified as long-term or short-term. If you hold the asset for more than one year before you dispose of it, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term. To determine how long you held the asset, count from the day after the day you acquired the asset up to and including the day you disposed of the asset.
In 2013, and 2014, harvesting losses could be an even more attractive strategy for high-income investors. That’s because of three tax increases that took effect in 2013:
The highest tax rate on long-term capital gains increased to 20% from 15%
A new 3.8% Medicare surtax for high-income taxpayers pushed the highest effective long-term capital gains tax to 23.8%
The top tax bracket is now 39.6% for ordinary income, nonqualified dividends, and short-term capital gains. The previous top rate was 35%. With the Medicare surtax, the effective rate can now be as high as 43.4%.
Generally, for most taxpayers, net capital gain is taxed at rates no higher than 15%. Some or all net capital gain may be taxed at 0% if you are in the 10% or 15% ordinary income tax brackets. However, beginning in 2013, a new 20% rate on net capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the new 39.6% ordinary tax rate ($400,000 for single; $450,000 for married filing jointly or qualifying widow(er); $425,000 for head of household, and $225,000 for married filing separately). Net short-term capital gains are subject to taxation at your ordinary income tax rate.
Even if you won’t be hit by higher rates, tax-loss harvesting can still be an effective tax strategy, potentially helping to reduce the costs of rebalancing, which is needed to ensure that your asset allocation (investment mix of equity, fixed income and cash equivalents) is aligned to your investment time frame, financial needs, tax rates, and comfort with volatility.
Here is a handy chart published by Keebler and Associates on how to harvest 2012, 2013, and Capital Gains.
Use this chart as a starting point for analyzing whether the strategy would be beneficial for you.
Click Here to see the chart.