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How to Make Tax Loss Harvesting Work for You

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

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Tax loss harvesting is defined by Investopedia as “the selling of securities at a loss to offset a capital gains tax liability.” This is a common technique investors use to eke some benefit from a loss on a security that is held in a taxable account.

As simplistic as it may sound, a loss on a security — such as an individual stock, bond, mutual fund or exchange-traded fund (ETF) — means that its market value is lower than what you paid for it. Losses on securities can be deducted for tax purposes if realized in a taxable account. Securities held in a tax-deferred retirement account like an IRA or a 401(k) are not subject to taxes on any gains or losses resulting from their sale.

How tax loss harvesting works

If shares of a security are held for less than one year, any gains or losses are considered short-term for tax purposes. This means that short-term gains would be taxed at the same rate as any other regular income that you earn from salary, self-employment or other sources. If the shares are held for more than one year prior to the sale, any gains would be taxed at the long-term capital gains rate, which might be lower than your tax rate on other income.

The concept of tax loss harvesting is that the losses realized on the sale of securities during the year can be used to offset gains that are realized on the sale of other securities or other income.

Let’s say you purchased 100 shares of XYZ company stock at a cost of $20 per share. The cost of these shares is $2,000. The shares fall to $10 per share, making the total value of the shares $1,000. If you sold the shares, you would realize a loss of $1,000.

Let’s also say that you sold 200 shares of ABC company during the year at a total gain of $2,500. This gain normally would be taxed at the appropriate rate.

Using tax loss harvesting, you could net the loss of $1,000 from the sale of the XYZ shares against the $2,500 gain from the ABC shares to reduce your overall capital gains for the year to $1,500.

These are the basics; however, it’s not quite so simple in practice. It’s important to note that the examples above and throughout this article will ignore both state income taxes and the transaction costs to buy and sell the securities. Each state handles capital gains and losses differently, so the impact will vary. Transaction costs to buy a security are added to the cost basis, while transaction costs to sell serve to reduce the amount realized, and that is subject to a gain or loss.

Long-term vs. short-term gains/losses and the leftovers

The rules for offsetting gains and losses specify that gains and losses of the same type should first be used to offset each other. You’ll need to look at any gains and losses realized during the year and match short-term gains with short-term losses and do the same with long-term gains and losses.

If the losses of one type exceed the gains of that same type, the excess losses then can be applied to other capital gains.

For example, if you had $3,000 in short-term capital losses for the year but only $2,000 in short-term capital gains for the year, then the excess $1,000 in short-term losses could be applied against any long-term capital gains for the year.

Note that capital gains distributions from mutual funds or ETFs also can be offset by capital losses realized elsewhere.

To the extent that you have excess capital losses that can’t be applied against capital gains for the year, the IRS says you can deduct up to $3,000 of these losses ($1,500 if married filing separately) against other taxable income. Any excess losses above that amount can be carried forward into subsequent years.

Katie Brewer, a fee-only certified financial planner and president of her Dallas-area firm Your Richest Life, deals with this issue in virtually serving many of her (primarily) Generation X and Generation Y clients. She indicated that a number of her clients have concentrated positions in employer stock that they try to diversify by selling a portion of each year. Brewer looks for losses elsewhere in their taxable holdings, or for specific shares of the employer stock that may have declined in value, to offset some or all of the gains from the sale of the employer shares to minimize the tax hit.

What is the wash-sale rule?

The IRS defines a wash sale as occurring when a security is sold at a loss and then the same or a substantially identical security is purchased within a 30-day window before or after the sale.

As you might imagine, this can get complex rather quickly. If you sold shares of IBM stock and realized a loss, that’s pretty straightforward.

On the other hand, if you sold Vanguard’s S&P 500 mutual fund at a loss and then turned around and purchased Fidelity’s S&P 500 mutual fund within the specified the time frame, that could well be considered a violation of the “substantially identical” rule. However, if you instead purchased a mutual fund that invested in the total stock market (and a different benchmark index from the S&P 500), you likely wouldn’t be in violation.

There is one other area for caution using the IBM example. If you sold your shares in a taxable account to realize a loss and then turned around and purchased IBM shares in an IRA account (as an example), you would be considered in violation of this rule if the purchase was within the specified time frame.

If you are found to be in violation of the wash-sale rule, you will not be allowed to use the tax loss when you file your tax returns.

Manual vs. automated harvesting

What we described above typically is done manually by investors and often occurs around the end of the year. There are also a number of robo-advisors that advertise tax loss harvesting as a service they offer to clients.

For example, Betterment offers automated tax loss harvesting and touts its Tax Loss Harvesting+ strategy as one that looks for opportunities to harvest losses on a regular basis and does a better job of reducing tax exposure than other automated models. It indicates that its service includes:

  • An automated algorithm
  • No extra trading costs associated with these transactions
  • Reinvestment of every dollar that is harvested
  • No short-term capital gains
  • IRA harvest protection against the “substantially identical” rule mentioned earlier
  • Rebalancing
  • Customer protection for realized losses

Wealthfront, another major robo-advisor, offers a similar service. Schwab Intelligent Portfolios cites tax loss harvesting as an offered service, as does SigFig for users of its managed account option. Personal Capital appears to offer some form of tax loss harvesting for investors with at least $200,000 in investable assets.

Tax loss harvesting can be a great service, but it’s important to understand how a robo-advisor does this, including how it decides where to invest the money from the tax loss sales.

Bottom Line

Tax loss harvesting is a potentially valuable tool that investors should be aware of. While nobody likes to lose money on investments, losses do happen. If those losses occur in a taxable (nonretirement) account, harvesting tax losses can help minimize your tax hit on gains elsewhere.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here

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Investing

Should You Pay Off Debt or Save Your Money?

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

You have a regular source of income, you’re paying your bills on time and you have some extra dollars left over each month. What should you do with that extra cash?

If you don’t have debt (lucky you!), then the choice is simple — save or invest as much as possible. If you have debt, however, the choice can be a bit murkier: Should you pay off your debt first or save? Here are some things to consider when asking yourself that question.

Three times that saving your money might be smarter

1. If you don’t have an emergency savings fund

Just when you’re cruising along, life can throw some unexpected and expensive curves your way. A sudden job loss, medical bills or car repairs can pop up out of the blue, and if you don’t have the funds to pay for them, you can end up seriously in the red. To cover unexpected costs, some may resort to high-interest credit cards and loans. Those kinds of moves can dig you into a financial hole that can take years to pay your way out of.

Saving up a healthy emergency fund can protect you in instances like these. How much should you save? Experts generally suggest that you should save an amount equal to between three and six months of living expenses. Depending on your individual circumstances, however, you may need more than that. (Check out this article to figure out how much to save and where to keep it.)

2. Your employer offers matching retirement contributions

If you’re fortunate enough to work for a company that offers a retirement plan with matching contributions, then consider making that method of saving a priority.

For example, if your employer offers to match your contributions dollar-for-dollar up to 6% of your salary in a 401(k) plan, then contribute at least that much, if possible. The money can then grow in a tax-free or tax-deferred 401(k) until you withdraw it in retirement — all that compound interest can really add up over the years. If you don’t contribute up to that amount, you’re leaving free money on the table.

Note, however, that If you need to withdraw these funds early (before the age of 59 and a half and before the account is five years old) there will be penalties to pay. That makes this a better tool for long-term savings rather than for the short-term or as an emergency savings fund.

3. Your debt has a very low interest rate

Debt gets a bad rap — often for good reason — but in some cases, carrying your low-interest debt and investing or saving your funds instead may be more beneficial. For example, the current fixed interest rate for direct subsidized and unsubsidized student loans is 5.05%, and the average 30-year fixed mortgage rate is about 4.3%. The stock market, on the other hand, has gone up an average of 10% a year since 1926.

Beyond comparing interest rates, however, you also need to assess how much risk you’re willing to take and how much access to your savings that you’ll need. Of course, there are no guarantees that your investments will perform well, and paying down debt comes with zero risk. Savings accounts are a less risky saving option, but the average interest rate is often less than 1 or 2%. Other options, such as individual retirement accounts (IRAs), have restrictions on how the funds can be used outside of retirement.

Four times debt repayment may be more beneficial

1. You have high-interest debt

It’s hard to get ahead of high-interest debt, because compound interest is working against you. Credit card interest rates, for example, average between 15 and 20% — an amount which adds up quickly. If you make the minimum payment, you may not even be making a dent in the principal amount owed, and you can spend years just paying interest. Calculators like this one can help you figure out just how much interest you’ll pay and how long it will take to pay off.

If you have high-interest debt, make sure you explore all the options for paying it down, including consolidating your debt and researching balance transfer cards.

2. Your debt doesn’t offer any benefits

Though your debt is costing you in interest, you might find that some loans may offer useful perks. For example, federal student loans may offer tax benefits and even loan forgiveness programs for eligible borrowers. Similarly, there are tax write-offs for mortgages and in many cases, the money you invest in a home will pay off down the line when you sell your property.

On the other hand, the debt on the credit card you maxed out to pay for that trip to Cabo comes with no benefits — just a bunch of interest. High-interest debt with no benefits should be at the top of your pay-off priority list.

3. You want to raise your credit score

While there are many factors that go into determining your credit score, the amount of debt you carry is an important component. If you plan to buy a home or secure a loan in the near future, take a look at your debt-to-income ratio (DTI), which many lenders consider before approving you for a loan. If your DTI is high, you may want to consider paying off some debt before applying for that new loan, which may result in lower interest rates for you later.

4. Your debt stresses you out

Debt can take an emotional and physical toll on people, ranging from depression to insomnia and more. When it feels like a black cloud hanging over your head and it’s affecting your life in negative ways, it may be in your best interest to prioritize paying debt off first.

Should you pay off debt or save?

Of course, saving vs. paying off debt early doesn’t have to be an either/or situation — ideally, you can do both at the same time. If, however, a choice must be made between the two, there are many factors to consider. As with most financial moves, there are no cut-and-dry rules, and the best one for you will depend on your individual circumstances.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Julie Ryan Evans
Julie Ryan Evans |

Julie Ryan Evans is a writer at MagnifyMoney. You can email Julie here

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Investing

How to Make Money in Stocks

Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.

Putting money in the market is well-worn financial advice for a reason: Investing in stocks is one of the best steps you can take toward building wealth.But how, exactly, is that wealth built? How is money earned by purchasing stock market holdings, and what can you do to maximize the gains you make from your own portfolio?

How to make money in stocks: 5 best practices

The way the stock market works — and works for you — is as simple as a high school economics class. It’s all about supply and demand, and the way those factors affect value.

Investors purchase market assets like stocks (shares of companies), which increase in value when the company does well. As the company in question makes financial progress, more investors want a piece of the action, and they’re willing to pay more for an individual share.

That means that the share you paid for has now increased in price, thanks to higher demand — which in turn means you can earn something when it comes time to sell it. (Of course, it’s also possible for stocks and other market holdings to decrease in value, which is why there’s no such thing as a risk-free investment.)

Along with the profit you can make by selling stocks, you can also earn shareholder dividends, or portions of the company’s earnings. Cash dividends are usually paid on a quarterly basis, but you might also earn dividends in the form of additional shares of stock.

Micro-mechanics of how stocks earn money aside, you likely won’t see serious growth without heeding some basic market principles and best practices. Here’s how to ensure your portfolio will do as much work for you as possible.

1. Take advantage of time

Although it’s possible to make money on the stock market in the short term, the real earning potential comes from the compound interest you earn on long-term holdings. As your assets increase in value, the total amount of money in your account grows, making room for even more capital gains. That’s how stock market earnings increase over time exponentially.

But in order to best take advantage of that exponential growth, you need to start building your portfolio as early as possible. Ideally, you’ll want to start investing as soon as you’re earning an income — perhaps by taking advantage of a company-sponsored 401(k) plan.

To see exactly how much time can affect your nest egg, let’s look at an example. Say you stashed $1,000 in your retirement account at age 20, with plans to hang up your working hat at age 70. Even if you put nothing else into the account, you’d have over $18,000 to look forward to after 50 years of growth, assuming a relatively modest 6% interest rate. But if you waited until you were 60 to make that initial deposit, you’d earn less than $800 through compound interest — which is why it’s so much harder to save for retirement if you don’t start early. Plus, all that extra cash comes at no additional effort on your part. It just requires time — so go ahead and get started!

2. Continue to invest regularly

Time is an important component of your overall portfolio growth. But even decades of compounding returns can only do so much if you don’t continue to save.

Let’s go back to our retirement example above. Only this time, instead of making a $1,000 deposit and forgetting about it, let’s say you contributed $1,000 a year — which comes out to less than $20 per week.

If you started making those annual contributions at age 20, you’d have saved about $325,000 by the time you celebrated your 70th birthday. Even if you waited until 60 to start saving, you’d wind up with about $15,000 — a far cry from the measly $1,800 you’d take out if you only made the initial deposit.

Making regular contributions doesn’t have to take much effort; you can easily automate the process through your 401(k) or brokerage account, depositing a set amount each week or pay period.

3. Set it and forget it — mostly

If you’re looking to see healthy returns on your stock market investments, just remember — you’re playing the long game.

For one thing, short-term trading lacks the tax benefits you can glean from holding onto your investments for longer. If you sell a stock before owning it for a full year, you’ll pay a higher tax rate than you would on long-term capital gains — that is, stocks you’ve held for more than a year.

While there are certain situations that do call for taking a look at your holdings, for the most part, even serious market dips reverse themselves in time. In fact, these bearish blips are regular, expected events, according to Malik S. Lee, CFP® and founder of Atlanta-based Felton & Peel Wealth Management.

So-called market corrections are healthy, he said. “It shows that the market is alive and well.” And even taking major recessions into account, the market’s performance has had an overall upward trend over the past hundred years.

4. Maintain a diverse portfolio

All investing carries risk; it’s possible for some of the companies you invest in to underperform or even fold entirely. But if you diversify your portfolio, you’ll be safeguarded against losing all of your assets when investments don’t go as planned.

By ensuring you’re invested in many different types of securities, you’ll be better prepared to weather stock market corrections. It’s unlikely that all industries and companies will suffer equally or succeed at the same level, so you can hedge your bets by buying some of everything.

5. Consider hiring professional help

Although the internet makes it relatively easy to create a well-researched DIY stock portfolio, if you’re still hesitant to put your money in the market, hiring an investment advisor can help. Even though the use of a professional can’t mitigate all risk of losses, you might feel more comfortable knowing you have an expert in your corner.

How the stock market can grow your wealth

Given the right combination of time, contribution regularity and a little bit of luck, the stock market has the potential to turn even a modest savings into an appreciable nest egg.

Ready to get started investing for yourself? Check out the following MagnifyMoney articles:

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Jamie Cattanach
Jamie Cattanach |

Jamie Cattanach is a writer at MagnifyMoney. You can email Jamie here

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