Tax-loss harvesting is a term you’ve probably heard but don’t know what it means. It may seem obscure, but it’s a good weapon to have in your investing arsenal. So just what the f**k is tax-loss harvesting?

 Dan Egan, the Director of Behavioral Finance at Betterment is joining us to talk about Tax Loss Harvesting. We discuss what it is, how it works and what sort of benefits it provides you as a long-term investor. Tax-loss harvesting is the selling of securities at a loss to offset a capital gains tax liability.

What is Tax-Loss Harvesting?

Losing money on an investment stinks but there is a way to soften the blow a little; tax-loss harvesting. TLH means you sell an investment that has lost money. By harvesting investment losses, you can offset taxes on short-term gains and income.

You replace the investment that was sold with a similar one to keep your asset allocation the same. Okay, that’s a little confusing for us lay people. Keep reading. Here’s an example of how it works.

You bought $100 worth of Apple stock. After six months, it’s only worth $70, so you sell it at a loss of $30 and buy a similar stock, like Microsoft. At tax time, you let the IRS know that you had that $30 loss, and they will reduce your taxable income by that $30.

TLH used to be something only very high worth investors could take advantage of because it’s such a labor-intensive process. It takes a lot of tax planning.  If you use a personal financial advisor or tax advisor they should offer this benefit to you.

Now computer algorithms can do it in seconds. If you invest through Betterment, this is done for you behind the scenes automatically and for free.

Benefits of Tax-loss Harvesting

TLH is a form of tax deferment. You will have to pay taxes on that $30 you lost in Apple eventually because you embedded a future gain when you bought a similar stock, Microsoft.

But you won’t sell that for a year or more so you’ll be charged the long-term gains rate, which is lower than the short-term rate.

For tax purposes, inflation works in your favor here because that $30 is worth more now than it will be in the future when you pay your tax bill. Because of inflation, paying taxes later is better than paying them sooner because it erodes the actual value of the taxes you will eventually pay.

You know how people tell you that getting money back on your taxes (thrilling as it is) is a bad thing because of that money, your money, has been loaned to the government tax-free? Well, you can use TLH to turn the tables. TLH is like getting a loan from the IRS on which you’re earning money on over time.

Realized losses on investments can offset gains and reduce ordinary taxable income by as much as $3,000 per year.

Taxes Everywhere!

You pay income tax of course, and there are various types of taxes you pay on your investments too.

Capital Gains

A capital gain is a difference between the price you paid for an asset and the higher price you sold it for. The IRS wants a cut off that profit, and they take it in the form of a capital gains tax. There are realized and unrealized capital gains. Gains are not realized until the asset is sold.

The government wants their cut, but they also want you to be a long-term investor.

If you hold an investment for less than one year, it’s considered a short-term investment, and you will pay a higher tax rate, the same rate that your income is taxed at. Selling investments in the short term are considered a job in a way, and you’ve taxed accordingly.

If you wait more than a year to sell, you will be taxed at a much lower rate, no more than 15%. That’s a substantial difference so be sure you take that into account capital loss when you’re deciding whether or not to sell.

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