The end of the calendar year is when many investors execute trades in taxable accounts for tax purposes. To reduce capital gains taxes, they sell underwater positions to realize losses to offset realized gains. If doing so can put you into a lower tax bracket, loss harvesting can make quite a bit of a difference in the amount of taxes you have to pay, notes Scott Chan, editor of Investing Daily.
Here’s how this strategy works: If you have a net capital loss for the year, you can offset it against your other income for a maximum of $3,000 per year. Any losses over $3,000 can be carried over to future years.
Capital gains are separated into long-term (LT) and short-term (ST) gains. Gains on assets held for more than one year are considered long term. Gains on assets held for one year or less are considered short term. Note that the tax rates on qualified dividends are the same as the rates for LT gains and the tax rates on non-qualified dividends are the same as the rates for ST gains.
For those new to investing, capital gains are when you realize a profit by selling something at a higher price than when you bought it. Dividends, on the other hand, are regular payments, typically out of profits, corporations pay out to shareholders.
Thus, if you sold some options, even though the cash inflow acts like a dividend, the profits you realize would be considered a ST gain (unless you wrote a long-dated option and held the position for more than a year, in which case it would be a LT gain).
LT gains are taxed at rates of 0%, 15%, or 20%, depending on your tax bracket. ST gains are taxed at your ordinary income tax rate, which could be 10%, 12%, 22%, 24%, 32%, 35% or 37%, again depending on your bracket.
If you like the stocks you are taking losses on, you can always buy back the stocks at a later date. Just be careful to wait more than 30 days to buy them back, or you will trigger the wash sale rule and won’t be able to claim deductions on the losses.
The IRS says that you cannot buy the same or a substantially identical security within 30 calendar days before or after selling a security for a loss.
