The window is closing. As 2023 approaches its end, so do tax planning opportunities. Tax planning is the process of arranging financial affairs to minimize your tax liability. This is often referred to as tax planning, or tax-effective investing.
Tax planning comprises many considerations. These include income amount, income timing, type of income generated and investment decisions. Tax planning can often go hand-in-hand with retirement planning. For example, contributing to your company’s retirement plan (such as a 401k, 403b or SIMPLE), reduces your current year’s taxable income while creating a self-funding retirement account.
Investment specific strategies center around the government’s allowance to use realized losses to offset realized gains. But there are a few caveats, definitions, and dates to be aware of. First is the date. Since taxes are filed based on calendar year, any trading must be executed by December 31st.
Now let’s define a few terms. Gains and losses are straight forward, less understood is the term “realized.” The term “realized” simply means an investment was sold. So, a “realized gain” means you sold an investment with a gain and a “realized loss” means you sold an investment with a loss. “Realized” differs from “unrealized,” which means you have yet to sell the position, but it may have a gain/loss on the books.
The basis of all tax-effective investing strategies utilizes the allowable loss/gain offset. This is referred to as Tax Loss Harvesting (TLH). TLH purposefully realizes a loss to make gains tax-free. TLH helps reduce your tax liability by reducing the capital gains taxes. Without the utilization of TLH, realized gains would be subject to capital gains taxes, which could be as high as 20% and may also be subject to the 3.8% net investment income tax (NIIT).
The goal of investing is to generate positive returns. Gains, however, are not always delivered via defined linear growth paths. Real world investing comes with volatility which can include declines. If realized (sold), losses can generate economic value by shielding gains from tax exposure contributing to your after-tax wealth. Even better, losses do not expire in the year taken. Losses can be carried forward to future years.
There are a couple caveats to be aware of.
- TLH only applies to taxable accounts, such as individual, joint, and trust accounts.
- Realized losses can indefinitely offset realized gains and reduce ordinary income up to $3000 annually.
- Realized losses can be carried forward to future years if losses exceed gains.
- To reduce TLH abuse, the government instituted a 30-Day Wash Rule. A realized loss is disallowed should the investment be repurchased within 30 days. To comply with tax law, financial advisors will either purchase a similar investment or wait 31 days before repurchasing the investment.
Attention to tax planning and TLH is a natural aspect of wealth management as the year-end deadline approaches. Financial advisors and accountants alike focus on value-add strategies that may not present themselves in performance calculations but can clearly benefit your after-tax wealth.
Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it relates to your personal circumstances.
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