Capital gains taxes are the taxes you may have to pay when you sell investments at a profit. Although long-term capital gains taxes are lower than short-term capital gains taxes, any type of taxes you owe can still reduce your effective returns.
The good news is, there's one simple technique you may be able to implement before the end of 2021 that could lead to a big reduction in the capital gains taxes you may owe for the year. Here's what it is.
Will this method of reducing capital gains taxes work for you?
If you'll owe capital gains taxes for the 2021 tax year, there's an easy option that could be available to help you to reduce the balance due to the IRS. You can harvest tax losses.
You pay capital gains taxes only if you sell your stocks at a profit and your income is above the threshold where the capital gains tax rate increases from 0%. But you have the option to offset your gains if you have capital losses. You can declare a capital loss if you sell stock at a loss.
Say for example that you made a $1,000 profit on some stock you sold this year. But you also have some investments in your portfolio that have performed poorly and that you've lost money on. If you sell those investments at a $1,500 loss, you could offset the entire $1,000 that you gained -- bringing your capital gains bill down to $0.
As for the extra $500 in losses, if you haven't made enough gains to balance out the amount you're down, you can actually use capital losses to reduce taxable income from other sources. You can deduct up to $3,000 in capital losses from wages or other taxable income such as interest income or taxable distributions from retirement plans. And any unused losses exceeding this amount can carry over into subsequent tax years, giving you a deduction in the future.
Is tax loss harvesting right for you?
Before you execute this strategy, it's important to remember that selling a stock when the share price is down from where you bought it means you are locking in losses.
If you still believe in the investment and think there is a chance that the stock price could recover and you could end up turning a profit in the long run, then it may not make sense to sell and accept a capital loss just to offset capital gains taxes. That's especially true because capital gains are taxed at a lower rate than ordinary income, so your tax bill may not be that huge on your investment gains anyway.
But if you believe that conditions have changed and you're unlikely to recover your money anytime soon, then selling before the end of the year could be just the ticket to reducing your obligations to the IRS. Just be sure to weigh your decision carefully and make a fully informed choice about whether tax loss harvesting is a strategy you want to try for the 2021 tax year.