Many people wait until the end of the year before thinking about tax planning. That leaves them scurrying at the last minute to try to take advantage of ways to cut their taxes, and often, the strategies they use don't work as well as they would if they were more diligent about paying attention throughout the year.
Tax loss harvesting is one of the most commonly used strategies that investors have to cut their tax bills. Harvesting tax losses serves the dual purpose of culling losing investments from your portfolio and reaping some tax savings in the process. Yet if you wait until everyone else is looking to use the tax loss harvesting strategy at the same time, it can end up costing you money.
How tax loss harvesting works
Most taxpayers don't have to worry about any tax implications from rising and falling values of the stocks in their portfolio. As long as you own a stock and don't sell it, you won't have to pay any taxes on any appreciation in their value. The day of reckoning comes when you sell your shares, as you'll have to pay capital gains tax on any profit that you've made from your investment since you bought it.
With an unsuccessful investment, selling results in a capital loss. Taxpayers can generally use capital losses to offset capital gains on other investments that they've sold. Even if you don't have enough capital gains to balance out your capital losses, you can still take up to $3,000 of your remaining capital losses and use it to offset income from other sources, such as wages, interest income, or taxable retirement plan distributions.
Why earlier is better
It's easy to understand why so many people wait until late November or December before harvesting tax losses. The natural inclination to delay thinking about taxes until the last possible moment is particularly compelling as the holiday season approaches and other priorities take precedence. In addition, it's painful to sell out of a losing stock, as it means that you've ruled out any chance of getting that lost money back.
Yet by the end of the year, everyone knows the stocks that are most likely to get sold by those seeking to harvest tax losses. For instance, this year, some well-known Chinese internet stocks have gotten hit hard, as trade disputes with the U.S. and fundamental competitive challenges to various business models have raised doubts from investors. Those stocks are likely to be candidates for tax-loss selling.
The problem is that those who want to buy beaten-down stocks also know that tax loss harvesting will accelerate at the end of the year. It therefore makes sense to wait to buy until selling activity is at its peak. That way, buyers will end up paying the lowest possible price for the stock -- and that reduces the amount of money sellers get when they sell their shares.
Get in ahead of the crowd
By contrast, if you sell your shares before most other people do, then you'll often get a higher price than you would have if you'd waited. Sure, your tax loss won't be as large, so you won't get as much tax savings. But it's always smarter to avoid a big loss in the first place, and it's not smart to see the value of your investment go down just because the size of your tax break will rise proportionately.
In addition, if you still believe in a stock but still want to reap the loss, moving quickly can let you take advantage of other tax loss harvesters. The wash sale rules require you to wait more than 30 days before you buy back a stock after claiming a tax loss. But if you sell stock in October, that'll put you in position to repurchase it in November or later. That could make you a buyer at the same time that most procrastinating tax loss harvesters are only starting to sell.
Tax loss harvesting is bittersweet, since it means locking in a loss on your investments. However, it's nice to get a silver lining at tax time. To get the most out of tax loss harvesting, don't wait -- get started today.