I can’t count how many times this year I’ve raised cash for client withdrawals.This is a common part of our job; retirees need money to live! Clients rely on our knowledge to help them minimize their tax liability when generating cash out of their investments.
So far in 2024 the market has done well, up 13% year to date (even with this late July dip). When clients need money I’ve got to decide if we’re going to incur capital gains, and cause tax for clients, or is there a way I can minimize these capital gains and taxes?
With a lot of these recent cash raises I’ve been able to see the benefit of previous tax-loss harvesting in action!
First, what is tax-loss harvesting?
Tax-loss harvesting is a strategy used by investors to minimize taxes on investments. It involves selling securities that have experienced a loss to offset capital gains from other investments. By realizing losses, investors can reduce their taxable income and lower their tax bill.
However, to maintain a similar investment exposure, investors typically replace the sold securities with a similar but not identical investment to avoid violating IRS "wash sale" rules. A wash sale is when you sell a security at a loss for the tax benefits but then turn around and buy the same or a similar security within 30 days. Tax-loss harvesting is particularly advantageous in taxable investment accounts where capital gains taxes apply. It's a proactive approach to managing investment taxes and can enhance overall after-tax returns in a diversified portfolio.
How can it save you money on taxes? Let me give you an example.
Our client Betty needs some cash, say $20,000 to redo her roof. We’ve determined the best place to withdraw this money is not from her IRA, but her brokerage account. This is because IRAs are taxed at ordinary income rates whereas brokerage accounts are taxed at capital gains rates, typically 15%.
Her investments have grown so her estimated capital gains is $5,000. $5,000 x Long-term capital gains rate of 15% = $750 in tax due.
But wait…back in 2022 we executed some tax-loss harvesting for Betty! She had paper losses of $35,000 and we harvested those losses.
Betty didn’t have capital gains of $35,000 in 2022 so she didn’t get to use these losses against gains. One of the good things about capital losses is that they are ‘carried-forward’, meaning you can use them in future tax years.
Betty got to use some of these losses to reduce her taxes in 2022, 2023, and now even in 2024. So this $5,000 in capital gains she incurred for her roof will actually be offset by action we took back in 2022.
This is real-life money saved for Betty! And a good example of why using an advisor can help you even beyond just investment selection and discipline.
Some disclaimers: You shouldn’t just blanket tax-loss harvest your accounts when they take a dip. This sometimes means you spend more time in cash so you could reduce your return if you’re not careful. There are the wash-sale rules that we mentioned above to consider, and in an IRA there are no capital gains so tax-loss harvesting is pointless.
But once you get the idea of harvesting losses and the few rules, you should consider this during investment dips.
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