As summer winds down, most people aren't thinking much about their tax returns. That's unfortunate, because some tax-saving strategies work a lot better if you don't wait until the last minute to use them.
One such strategy is called tax loss harvesting. For the most part, those searching for ways to reduce their tax bill only resort to selling off their losing investments as the end of the year approaches. But in many cases, if you identify your losers earlier, you can get a better result as well as reap valuable tax benefits.
The basics of tax loss harvesting
Investors in the U.S. are fortunate in that they generally don't have to recognize profits on successful investments while they still own them. Instead, a capital gain or loss is generated only when the investor sells the investment. Comparing the proceeds from the sale to the initial amount invested -- adjusted for any changes in tax basis -- determines whether you'll have a capital gain or a capital loss on the sale.
At the end of the year when you're preparing your tax return, you'll be able to offset any capital gains from winning investments by using capital losses from less-successful investments. If you have any losses left over after offsetting all your gains, then you can use an additional $3,000 in losses each year to reduce your taxable income from other sources, including compensation and investment income.
Getting ahead of the crowd
A couple of things make tax loss harvesting popular at the end of the year. First, most people procrastinate when it comes to tax strategies, waiting until the last possible moment to use them. In this case, the last sale date is Dec. 31, and so November and December end up being the most popular times for investors to make sales motivated by tax losses. In addition, most investors hate to lock in a loss by selling a losing position, instead hoping that a rebound will make the position profitable.
However, smart investors know well in advance which stocks are most likely to be popular candidates for tax loss harvesting, and so if they're interested in buying those stocks, they'll tend to wait until their share price comes down as a result of sellers flooding the market. You'll notice that stocks that are down for the year often see their losses get bigger toward the end of the year, and that's largely due to the supply-and-demand imbalance between buyers and sellers of shares. Sellers can't wait beyond Dec. 31, but buyers can outlast them, letting the stock price drop before swooping in to make purchases later.
An early start can give you a better sale price
If you don't want to fall prey to this situation, it's smart to harvest potential losses before most other investors start thinking about it. By doing so, you'll lock in a price that hasn't yet been artificially pushed down by massive selling pressure. That will result in a smaller loss, and although that'll reduce the tax benefit from selling, it's still better than actually losing a lot more money.
Indeed, with the S&P 500 and Nasdaq Composite at all-time record highs, there's arguably no better time than now to look at reducing positions on investments. If the stock market starts heading lower, then investors often sell off the worst performers first, which would lead to more downward pressure on share prices.
Time to get back in
If you want the tax loss but still think the stock could recover, getting started early gives you an opportunity other investors won't have. Under the wash-sale rules, you can't claim a loss on a stock sale unless you wait 30 days before buying the stock back. So if you sell now, you could put yourself in position to buy the stock toward the beginning of fall -- giving you the choice of potentially waiting until November or December, when most investors are just getting around to using the loss harvesting strategy and want to dump their shares at whatever price they can get.
Obviously, the best result for an investor is never to lose money in the first place. However, it's unrealistic to expect a 100% successful track record for your investments. Tax loss harvesting at least lets you get some offsetting tax savings to make up for the money you lost on your investment -- and the sooner you do it, the better it can work.