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Tax-loss harvesting: when investment losses can be a plus

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(Read caption) In this Wednesday, Sept. 16, 2015 file photo, a Chinese investor eats lunch as she monitors stock prices at a brokerage house in Beijing.

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It takes a lot of discipline to stick to an investment strategy that calls for patience while stock prices are falling. The urge to do something, to take action, can be overpowering. Unfortunately, average investors more often than not choose the wrong course and end up hurting their long-term results because of decisions based on short-term conditions.

But a down market can present opportunities in the form of lower taxes if you know where to look. Selling stocks (or other securities) at a loss can potentially reduce your tax bill. That’s because the tax code allows investors to use up to $3,000 in capital losses each year to offset ordinary income, such as from wages and pensions. This is known as tax-loss harvesting, and there are important rules you must follow for it to work.

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First, you should understand the so-called wash sale rule. This prohibits you from taking a deduction for a loss on a securities sale if you buy “substantially identical” securities within 30 days before or after the sale. In other words, you can’t sell stock at a loss when it’s down, turn around and buy back the same stock, and then deduct the loss. You can’t avoid the wash sale rule by simply buying the stock in a different account, either.

However, you can sell one stock at a loss and buy another as long as the replacement is not “substantially identical.” For instance, you can’t take a loss by selling Apple and then buy Apple back — but you can sell Google at a loss and then buy Apple.

Just because you are able to take a loss doesn’t necessarily mean that you should. The stock might still fit into your long-term investment goals, even at its lower price. There may be a replacement investment that fits equally well — but if there isn’t, you are changing your asset allocation. You run the risk of reducing the effectiveness of your portfolio over time, negating the benefit of taking the loss in the first place.

You must also consider the “tax bracket now versus tax bracket later” question. A tax-loss harvesting strategy is most effective when you expect your tax rate to be lower in the future, such as after you retire and your income drops. Additionally, capital losses offset capital gains before they are allowed as a deduction against ordinary income. (Say you have $5,000 in capital losses and $4,000 in capital gains. The first $4,000 of your losses offset the gains, leaving only $1,000 to deduct against ordinary income.) Since capital gains on investments held longer than one year aren’t taxed at all if you’re below the 25% tax bracket, taking the loss may wipe out tax-free capital gains.

There are other complicating factors that have to be weighed depending on your individual circumstances. For a taxpayer in a low tax bracket, taking a loss on depreciated stock may not create any tax benefit at all. However, if you receive Social Security benefits or a health insurance premium subsidy, taking the loss may drastically reduce your tax bill because of the way these items are treated in the tax code.

Tax-loss harvesting can be an effective tool for increasing overall portfolio efficiency if used properly. However it usually requires detailed analysis to make sure you avoid the potential pitfalls buried in complex tax rules. Working with a qualified professional may be necessary to put together a plan for managing the risks. But the next time you have investing losses, perhaps you’ll want to consider the possible perks from a tax perspective.

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