Most federal employees don’t think about their taxes until April 15th is around the corner, however, thinking about taxes long before it’s time to file gives you the opportunity to do some tax planning that can potentially reduce your tax bill.
That being said, the end of the year is a great time to use a tax planning strategy called tax-loss harvesting. This strategy involves selling investments such as stocks, exchange-traded funds (ETFs), and mutual funds to realize losses and then use them to offset taxable gains and other taxable income.
So, for the third installment of our tax planning series, we’re going to review how tax-loss harvesting can help most federal employees reduce their tax burden.
What Is Tax-Loss Harvesting?
What exactly is tax-loss harvesting? As mentioned earlier this strategy involves selling one of your investments at a loss and then using that loss to offset any capital gains you have for the year.
While it might seem counterintuitive to sell investments at a loss there can be a significant tax benefit to selling a losing position since these losses can not only be used to offset capital gains but also can offset up to $3,000 of ordinary income each year.
Although this strategy is fairly straightforward, it’s worth reviewing an example and a common mistake.
Let’s Look At An Example
For example, let’s say you have a capital gain of $15,000 from a mutual fund you bought less than a year ago (Investment A). Because you held the fund for less than a year, the gain is a short-term capital gain and will be taxed at your ordinary-income tax rate rather than the lower long-term capital-gain rates that apply to investments held for more than a year.
If in the same year, you were to sell shares of another mutual fund that had a capital loss of $20,000 (Investment B). Your $20,000 loss would offset the $15,000 gain from Investment A, so you’d owe no taxes on the gain, and the remaining $5,000 loss would offset $3,000 of your ordinary income.
Additionally, the remaining $2,000 loss could be carried forward to offset income in future years. Another key point to remember is that you can and usually should reinvest the proceeds from the sale in a manner that is consistent with your investment goals, but you’ll want to avoid triggering a wash-sale – more on this next.
Finally, let’s say in this example your marginal tax rate is 24%, by harvesting the losses from investment B, you would have saved about $4,320 in taxes this year.
Beware Of The Wash Sale
Now that we’ve seen how effective tax-loss harvesting can be at reducing a tax bill, it’s time to review the major misstep often made when employing this strategy.
The most common error made when using this strategy is triggering a wash sale. The wash sale rule prohibits you from taking a tax deduction when you sell an investment at a loss and repurchase the same investment, or a substantially identical one, within 30 days before or after the sale.
This rule is intended to prohibit investors from locking in a tax break and then turning around and repurchasing the same investment (or a “substantially identical ” one).
Among tax planning strategies, tax-loss harvesting is one of my favorites since most federal employees with a taxable account (non-retirement) can utilize it to offset their capital gains and up to $3,000 of other income.
Yet, to successfully use this strategy, federal employees must take caution when reinvesting the proceeds to not accidentally trigger a wash sale and nullify their recognized loss.
Lastly, remember that financial planning is a multifaceted process, and you should ensure that any changes to your portfolio are aligned with your short and long-term investment goals. If you need help or aren’t confident in creating your financial plan, consult a fee-only Certified Financial Planner™.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.