Say you buy “ABC” for $40,000 and ABC drops 25 percent. You elect to swap and harvest by selling ABC for $30,000 and buying a similar holding “XYZ” with that $30,000. Because XYZ and ABC are similar, your basic investment plan is intact, but you have a $10,000 realized loss for tax purposes. In many cases, that $10,000 loss is not valuable.
Tax law dictates that the loss first be used to offset capital gains. That’s nice but the tax rate on long-term capital gains for taxpayers in the 12 percent marginal bracket or lower is functionally zero so a loss used to offset gains for these taxpayers has no value. The gain would have been untaxed anyway and the loss is used up.
If the loss exceeds the year’s gains, you can use $3k against your ordinary income on your current year 1040. That’s it. Three grand. You would then “carry forward” $7,000 of losses to the following year which must be first used to offset future gains. That 3k may be the only 3k used against ordinary income.
The other thing loss harvesting can do is reset basis lower causing future gains to be greater. In our example, after the swap you own XYZ with a basis of just $30,000. If XYZ recovers to $40,000 as would be the hope, otherwise why swap in the first place, you incur a $10,000 gain. If the gain is not offset by losses or loss carryforwards, the gain is taxed at the then prevailing capital gain rate which can be higher than the rate to which the loss applied.
Of course, real life is messier than this example. Most people have many holdings with multiple tax lots and face multiple possible tax rates through their investment time horizon. All this means multiple planning opportunities, or pitfalls.
Tax-loss harvesting is often presented as a short-term tactical decision but really it should be considered as part of a long-term strategic plan. In many cases, short-term tax savings cause larger future tax bills.
Reducing Income To Avoid Taxation On Social Security
My specialty is working with retirees so I see this pitch often. Because the portion of your Social Security payments that is taxable is determined by “combined income” which is your adjusted gross income (AGI) + nontaxable income + ½ of Social Security payments, lowering AGI can reduce the amount of Social Security subject to tax. This one makes the list because the impact is likely to be negative and few can pull it off.
The income range that increases the amount of taxable Social Security is often referred to as the “tax torpedo.” Taxpayers below or well above this infamous range will find that the strategy doesn’t work at all. Those below the range don’t have taxable Social Security anyway and those well above the range can’t get the combined income down far enough. That doesn’t stop the pitchmen.
By moving money from otherwise taxable accounts, into something that doesn’t generate interest or dividends, less Social Security can be taxable, the story goes. One way to do this is through non-dividend paying stocks but pitchmen favor a non-qualified annuity. The guarantee is some contracts can be appealing to seniors.