This is the time of year where financial advisors across the country meet with clients to discuss whether or not they should engage in "tax loss selling." Today we'll explore what tax loss selling is and whether you should be doing it.
Keeping Uncle Sam at Bay
Tax loss selling is a strategy you can use in your taxable investment portfolios (i.e. non-retirement accounts) to reduce your year-end tax bill. The way it works is that you look through your holding for any "unrealized losses." These are investments that are currently selling for less than what you originally paid for them. The IRS allows you to sell these investments and "lock in" the loss. You can then use this loss to offset any amount of realized investment gains and to offset ordinary income up to $3,000. And if you decide you still like that underlying investment, you can buy it back after 31 days.
More on the Mechanics
This strategy is also referred to "tax loss harvesting," and that's a great visual for how to think about it. It's like picking the dead leaves off a poinsettia to keep the whole plant looking pretty and fresh. You are temporarily shedding something ugly—and something new can grow back in its place. Importantly, you only do this in taxable portfolios. For many people, their long-term investing is done in retirement accounts like 401(k) or IRA accounts. This technique is not allowed in those accounts.
Some Red Flags to Watch Out for
Red flag number one is called the "Wash Sale Rule." You must wait a full 31 days before buying back the security you sold in order for the loss to qualify as an offset to your income. Another red flag to be careful of is knowing that if you choose to invest your tax lost proceeds in an allowable "similar but not substantially identical" security for that short 31-day time period, you risk the market moving against you and negating the tax benefit you got from this whole process.
Bottom line: If done correctly, tax loss selling can be an effective way to help reduce the bite that Uncle Sam takes out of your income. As the year comes to a close, it's worth having a conversation with your CPA and/or your financial advisor to see if this is a strategy that makes sense for you.