Harvest Time! Use this tax strategy before the end of the year to save money

Tax Loss Harvesting

The recent downturn in stocks this October has presented an opportunity for investors to save some extra money before tax time by using a strategy called Tax Loss Harvesting.

Example of Tax Loss Harvesting in action.

So what is it and how does it work? Well it's actually very simple. What it all comes down to is selling an investment that has gone down in value and replacing it with a similar investment. The goal is to "bank" a loss for taxes and keep the same exposure to the market. The loss is then used to offset other gains or provide you with a deduction on your taxes. Hurray!  Since you remain invested in the market you are able to enjoy the gains after the stock market turns back around.

I like examples, so I'll share one with you now.

Assume you purchased mutual fund ABC for $25,000 on October 1st. Your timing is terrible and the fund decrease in value down to $20,000 by the end of the month. You might not be happy about the decline in price but being a long-term investor you know the market will turn around and over time your investment should go up so you want to stay invested. What do you do? Strategically Harvest your Loss. You sell fund ABC and simultaneously (or shortly after) purchase fund fund XYZ. You know that fund ABC and XYZ are similar so you are ok switching one out for the other (maintaining your market exposure) but now have a $5,000 loss to use for your taxes. This is a short-term loss so (assuming a 35% ordinary income tax rate) this loss is worth approx. $1,750 to you. Then the market proceeds to go back up and your investment is back up to the original $25,000. If you never harvested those losses you would be out the $1,750.  (this depends on your personal tax situation and assumes you have short-term gains of $5,000).

You have to be aware of the "wash-sale" rule which says the investments cannot be "substantially identical" in nature. This would be like swapping Fund ABC Class A for Fund ABC Class B. The same exact fund but with different fee structures.

See I told you this was easy. Well, maybe it's not that easy but hopefully this helps a little bit. If you are confused and need help with your own Tax Loss Harvesting Opportunity post it in the comments below. I'll help you out and everyone will benefit!