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Financial Planning
Jul 2022

Finding Tax Relief Amidst Economic Turmoil

By Ken Cranstone, CFP®

While down markets usher in waves of fear, doubt, and uncertainty, they can also deliver us an opportunity to save money on taxes.

A Little Bit of Tax Background

When it comes to buying and selling securities in brokerage accounts, the IRS wants to know how much you pay for something and for how much you sell it. As you might expect, if you make money doing something, you are going to have to pay taxes on it.

Whenever you purchase an investment like a stock, the amount that you pay is referred to as your cost basis. At a future point when the investment is sold, you recognize either a taxable gain if you sell the stock for more than your cost basis or a taxable loss, if you sell it for less.

All of this information flows through to your annual 1099 tax form, and therefore to your tax return and tax bill.

The greater the taxable gains, the greater the tax bill. Though as mentioned previously, not everything sold at a future date is worth more than you paid for it. In instances where you generate a taxable loss, this amount offsets taxable gains, potentially reducing your overall tax bill.

Fun fact, net taxable gains at the end of the year are taxed at preferential rates, which are normally favorable compared to other income like wages.

“Selling” vs. “Getting Out”

When talking about the market it’s easy to conflate the terms selling and getting out of the market. This is because in order to get out of the market, you have to sell what you’re holding. So, we often think of these terms as interchangeable. That said, you can remain invested even when selling securities. Think of this like selling your home to buy a new one compared to selling your home to rent an apartment. In the former example, you’re still in the housing market, in the latter, you’re not.

So What is Tax Loss Harvesting?

Putting together the ideas above, we can provide a definition for Tax Loss Harvesting; the process of selling investments, which have declined in value to generate a taxable loss, and the subsequent purchasing of another investment with the proceeds to remain invested in the market. By pursuing a strategy of Tax Loss Harvesting, investors are able to extract a taxable loss from their portfolio that can be used to reduce taxes, while remaining fully invested for when the market rebounds.

Of course, we all want our investments to only go up, but that is not the reality in which we live. Instead, we need to find elegant ways to make lemonade out the market’s lemons.

A word to the wise; most strategies that have the ability to reduce your tax liability are mired with nuances and intricacies, which can unravel the entire benefit if they are not followed to the letter of the law. Please be sure to consult your tax or financial professional to discuss how tax loss harvesting can affect your specific financial situation.

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This commentary is for educational purposes only, and should not be construed as tax or investment advice.

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