Bragging about stock market losses is never in style, except when you're filing your tax returns. If you've been a victim of the stock market's wild ride and sold stocks at a loss in 2020, don't despair -- there's a special rule in the tax code that allows you a unique opportunity to turn your stock loss pain into a tax savings gain.
A smart way to profit from your pain
2020 was a year of unprecedented volatility in the financial markets -- you may have had stocks in your portfolio that performed extremely well while others were the underachievers you wish you never laid eyes on. Don't become bitter; focus on finding a better way to deal with losses by tapping into the power of tax loss harvesting -- a way to use losses to reduce or eliminate capital gains taxes in a taxable investment account.
Capital gains occur when you sell a stock for more than you purchased it. If you bought shares of stock for $1,000 and sold them for $5,000 in a taxable investment account, you have a $4,000 capital gain that you have to share with the IRS. If you held your investment for a year or less, you pay a short-term capital gains rate that is similar to the taxes you pay on your income from working a job -- those rates can be as high as 37%. Long-term investments (over a year) qualify for lower tax rates of 0%, 15%, or 20% depending on your income and filing status.
If you want to strategically reduce your capital gains taxes now and in the future, this is where tax loss harvesting comes in handy. You can offset capital gains with capital losses, invest your proceeds in other stocks that have the potential to grow, lower your tax bill, and transfer extra losses to future years.
Locking in losses isn't always a bad thing
Let's face it: losses can be devastating. But a loss in the stock market can lead to a victory on your tax return if you dig into the IRS rules that make this possible. You can write off your losses to offset short-and long-term gains of the same type and then use the excess to reduce the other type of gains.
For example, if you sold a long-term stock investment at a $20,000 loss and another long-term stock investment at a $5,000 gain, you can wipe out your entire $5,000 gain with the loss -- no taxes are required on the gain because your long-term losses exceeded your long-term gains! Next, you can use the remaining $15,000 loss to reduce short-term capital gains. Essentially, when you sell stocks at a loss, you can potentially reduce your capital gains taxes to zero and save thousands of dollars during tax time!
If 2020 was a brutal year for you and you ended up with no capital gains, you can still use the tax loss harvesting strategy to offset up to $3,000 a year of ordinary income ($1,500 if married filing separately) on federal income taxes and carry over the rest of your losses to reduce gains and income in future years. There's no limit to the amount of losses that can be carried forward -- you can continue to use losses from previous years to reduce your taxes until you've exhausted the entire amount of losses!
Get ready for a brighter future
Tax loss harvesting works magic on your tax return, but it should never stand in the way of your investing goals. Don't become overzealous and divorce great stocks just to take advantage of the tax perks this year; it's always best to invest for the long-term and give your portfolio a chance to keep growing.
Tax loss harvesting makes the most sense when you are in a higher tax bracket and have investments in your portfolio that have lost their sparkle. You can sell the investments at a loss, save money on taxes, and reallocate that money in places where your portfolio has a chance to grow even more. But fair warning -- don't attempt to buy the same or substantially identical stock within 30 days of taking the loss. That would be in violation of the IRS' wash-sale rules, and it's one of the exceptions that will disqualify you from taking advantage of the amazing tax benefits that a stock loss presents.
Tax loss harvesting is the mental breakthrough that you've been searching for this year -- you can still hold your head up high knowing you will receive incredible tax savings and have additional funds available to sprinkle some more attractive stocks throughout your portfolio.