Tax-Loss Harvesting: Making Lemonade Out of Lemons

You can lessen your tax burden when you sell stocks or bonds at a loss by offsetting the losses against capital gains.

Unless you’re someone who shorts stocks, falling share prices, such as we experienced last year, are probably quite painful.

But there is a way to lessen the pain a bit. It’s called tax-loss harvesting. The idea is to sell the worst of your holdings – the biggest dogs. This assumes you’re selling the shares at a loss.

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You can then use the total of your capital losses as an offset against your capital gains for tax purposes. If your losses exceed your gains, you can use up to $3,000 of the excess to offset your ordinary income for tax purposes.

If the excess is more than $3,000, you can carry it forward to future years. Each year you can use all of your losses to offset gains. And if the losses exceed the gains, again you can use up to $3,000 to offset ordinary income.

Depending on the amount of your capital gains and losses, the savings could be substantial. And then if you’re applying $3,000 against your regular income, you get a little bonus savings. Someone in the 22% tax bracket would save $660.

Example of Tax-Loss Harvesting

Here’s an example that may help you understand the concept. Say you sell some investments for a loss of $30,000, but others for a gain of $25,000. Your losses would offset all your gains for tax purposes. And you’d have $5,000 in losses left over.

You could use up to $3,000 of that to offset your ordinary income, and you could keep the remaining $2,000 to use in future years.

The tax savings would be $4,410, assuming a long-term capital gains tax rate of 15% and an ordinary income tax rate of 22%.

Given financial markets’ recent rollercoaster ride, now is a good time to think about tax-loss harvesting, Brian Concannon, head of digital adviser and mass affluent advice at Vanguard, wrote in a commentary exclusively for TheStreet.com.

Taking Advantage of a Falling Portfolio

“It’s never easy to see your portfolio decline in value,” he said. “During periods of market volatility, tax-loss harvesting provides many investors an opportunity to take advantage of that volatility and benefit from realizing losses that can be used to reduce their taxes in the future.”

Keep in mind that you can deploy tax-loss harvesting for bonds and other securities, in addition to stocks.

You can use tax harvesting to help rebalance your portfolio if your asset allocation is out of whack, Concannon said. So if you are overweight stocks, you can sell some of the dogs to lower the weighting and earn a tax benefit in the process.

To be sure, you don’t want to use the strategy willy nilly. You may own depressed shares of a company that is fundamentally strong.

You wouldn’t want to sell it just to gain a tax benefit. You would likely enjoy a much bigger benefit If the stock ultimately rebounds for the long term.