While we all have to pay taxes, and most just blindly accept this fact, there are some things we can do to minimize the impact. Below we’ll explain a major tax savings opportunity for 2022.
What is tax loss harvesting?
Tax loss harvesting or ‘TLH’ is a way to lower your tax liability by intentionally selling an investment at a loss. This is normally done to offset capital gains owed on other investments, but can also be applied against $3,000 of regular income (W-2 type).
How it works
Let’s say you sold an investment property for a $100k profit that will be treated as a long-term capital gain. If you’re in the 22% tax bracket, you’ll be taxed at a rate of 15% for long-term capital gains, bringing your total federal tax bill to $15k, plus any additional state taxes. Ouch.
But wait… you also decided to take a gamble on a penny stock in early 2022. Now that the market is getting thrashed, you’re down $10k on that investment. Because of this, you can sell the investment and apply the $10k loss against the $100k gain. In this example, you would now owe 15% tax on $90k, which is $13.5k. By selling your losing investment, you saved $1,500.
Ideal circumstances
The above situation isn’t ideal, as you are realizing a $13,500 loss. For most people, this would be a tough pill to swallow. But let me give you a more realistic example of how one can employ TLH and still sleep at night.
In 2020, when Covid-19 became prevalent around the world, the stock market took a quick, steep decline. I noticed that my main stock market holding, VTI, had incurred losses of around $15k. At the same time, I was also planning on selling a piece of land later in the year that would have a $50k gain. So I took the $15k loss on VTI and immediately bought VOO, an S&P 500 Index Fund ETF. This is basically an equal swap in my opinion, so I don’t really think I locked in a loss. The position easily recovered by the end of the year and now only shows up on my 2020 tax return as a $2,250 savings.
Wash sale rule
Effectively, the wash sale rule prevents you from selling an investment at a loss and then immediately re-purchasing a substantially identical investment within 30-days, either before or after the transaction. The key here is to avoid “substantially identical” investments. In my example above, VTI tracks the total market while VOO only tracks the S&P 500, which makes them very different, rather than identical. If you try to switch VTI for another total stock market fund, you may get hit with this rule.
Another tool for the toolbox
Here at Wealthy Idiots, we want to keep giving you tidbits of information that will help you in the long-run. None of this is a “one-size-fits-all”. Personal finance is just like it sounds: personal. But at the end of the day, we want to give you enough information to positively change your own future. Keep reading, and we’ll help you get there!
