No one likes to pay more in taxes than they have to, and tax-loss harvesting is one way to cut your tax bill.
In this segment of Industry Focus: Financials, Motley Fool analyst Gaby Lapera talks with Dan Caplinger, the Fool's director of investment planning, about the basics of tax-loss harvesting and how you can use it to cut your taxes. As Dan and Gaby explain, using tax-loss harvesting can help you find a silver lining in your underperforming investments.
A full transcript follows the video.
This podcast was recorded on Nov. 28, 2016.
Gaby Lapera: Dan, I figured we should start with tax-loss harvesting.
Dan Caplinger: You bet. That's the obvious place to start. It hasn't actually been a huge problem for a lot of investors over the past several years because we haven't had that many losses; the stock market has pretty much been shooting straight up. But most people will find even if you have a successful Investment portfolio, you can't escape having at least some stocks lose ground. And that's where tax-loss harvesting can really help, by selling off those stocks, taking those losses, and you're able to use them to offset either capital gains or, in some cases, other types of income to reduce your eventual tax bill.
Lapera: Yeah, this is really interesting. A lot of people don't realize that you have to pay taxes on capital gains. They think it's just free money. But it's income, so you have to pay taxes on that. Tax-loss harvesting, just like Dan said, is a great way to offset that. Another thing to keep in mind is -- I hadn't thought about this until today -- if you own index funds, a lot of them pay out dividends, and that also counts toward something you need to pay taxes for. So, keep that in mind. I just want to say that right now, because I totally almost forgot about that when I was thinking about which TurboTax program to buy.
Caplinger: Gaby, just to jump in there -- a lot of mutual fund investors, especially this year, now that the stock market has been going up for so long, sometimes they're going to get distributions toward the end of the year that are really big, and they're going to wonder, what the heck is going on here? The fact is, most mutual funds pay out a distribution. Some of it is just the dividend income that they accumulate over the course of the year. That's usually pretty modest. But if a fund has been successful, sometimes they'll make a really big distribution, and that's all the capital gains that all of their successful investments that they've decided to sell off during the year, it's those gains getting passed out to their fund holders. That's one reason why tax-loss harvesting can be smart, because you can use the losses that you harvest in order to offset those capital gains distributions that those mutual funds pay out to.
Lapera: Yeah, absolutely. Just a reminder to our listeners, there is a difference between short-term and long-term capital gains taxes. Short-term capital gains tax depends on your income, but I believe ... do you have the number off the top of your head, Dan?
Caplinger: It's a year or less, if you own something for one year or a shorter period of time, then you have to pay taxes on whatever your ordinary tax bracket is. That goes as high as 39.6%, depending on what your income is. Long-term capital gains, on the other hand, that's for stocks or other investments that you hold for longer than a year -- so, a year plus one day, or longer -- those get a preferential tax rate, and that depends on your tax bracket. For those who are in the lowest two tax brackets, those long-term capital gains are tax free, it's 0%. For everybody else, it's 15%, unless you're in the highest possible tax bracket, then it goes up to 20%. But that's still just barely half of what the ordinary income tax rate is at that point. So, it's a big tax savings, gives you an incentive to hold on to those stocks longer than a year if you have gains on them.
Lapera: Absolutely. So, definitely keep that in mind. That's one of the other benefits of following The Motley Fool's philosophy of being a long-term investor. Not to get too much like I'm drinking the Kool-Aid, but I totally am.