Tax bills strike fear in many people, as they expect their living standards to deteriorate due to  higher tax bills being enforced year-on-year. This has made methods to reduce tax bills very popular with more people looking to lower their outgoings and gain more money to support their needs. One of the ways to reduce your tax bill is through Tax Loss Harvesting.

Tax loss harvesting is the strategy of selling stocks at a loss to offset the amount of capital gains tax owed from the sale of lucrative assets. This can be a great debt management plan for investors. It’s typically used to limit short-term capital gains that are usually taxed at a higher rate than long-term capital gains. This helps to preserve investor’s portfolio value while reducing taxes at the same time.

How does tax loss harvesting actually reduce your tax bill? We will explore the answer to this and more throughout this guide, so make sure to continue reading.

How Tax Loss Harvesting Works

When assessing the annual performance of their portfolios, investors will use the tax loss harvesting strategy at the end of the year to see how it will impact their taxes. The strategy is also known as tax loss selling, as it involves the selling of stock to offset owed capital gains tax. To claim a credit against the profits realised in other assets, an investment that shows a decline in value may be sold.

In essence, tax loss harvesting is quite a simple strategy to learn. For example, a loss in value in Asset A could be sold to offset the increase in price of Asset B, which will eliminate the capital gains tax liability of Asset B. The main goal of this is to save money on taxes and has become a very common tool used by those who have knowledge of the financial market.

How to Manage Your Portfolio

Balancing your portfolio is very important, especially when you are selling assets at a loss which can potentially cause disruptions. It’s essential that investors carefully construct portfolios that can easily replace sold assets with a similar asset with better potential returns and lower risk. If you’re looking to get involved with tax loss harvesting, you should avoid buying the same asset that you have previously sold at a loss. This might violate the IRS wash-sale rule, which can result in your account being fined or restricted.

The Wash-Sale Rule

As mentioned above, the wash-sale rule requires that investors avoid purchasing the same stock that they have previously sold at a loss using the tax loss harvesting method. This threshold period for this rule is 30 days, so you could re-purchase the stock after this but it is still not recommended. Once it’s been decided that a transaction is considered a wash-sale, it voids the offsetting of capital gains which means that you will not have reduced your tax bill. Fines and restrictions can be applied to accounts if these wash-sales are abused.

You can avoid violating the wash sale rule with tax loss harvesting if you use ETFs that can track the same or similar indexes. This helps you to identify whether you should purchase a stock. If you sell one S&P 500 index ETF at a loss, you can purchase a different S&P 500 index ETF to harvest capital loss without violating the IRS wash-sale rule.