'Don't wait' to make this year-end move that could help cut your tax bill, says CPA

With just over a week of trading left, 2022 is shaping up to be a gnarly year for investors.

Since the start of the year, the S&P 500 has surrendered about 19%, and, depending on what you hold, your portfolio could look worse. If you bought Tesla stock at the start of the year, for instance, you're down more than 64% on the trade, as of Dec. 22.

For those seeing red on their portfolio page, there is one silver lining, though. If you sell an investment at a loss, the IRS allows you to use that loss to offset gains and income.

Taking advantage of these rules is a strategy known as tax-loss harvesting, and you have until the end of the year to do it if you want to lower your 2022 tax bill.

"Don't wait until after the end of the year," says Brian Schultz, a certified public accountant and tax partner at accounting and wealth management firm Plante Moran. "We always encourage clients to be proactive. You don't know when those losses are going to be beneficial."

Here's how tax-loss harvesting works.

To understand tax-loss harvesting, you first need to remember how capital gains taxes work.

When you sell an investment you hold in a taxable account for more than what you paid for it, you realize a capital gain. While profits from investments you've held for a year or less are taxed at your ordinary income rate, investments you've held for longer are taxed at the long-term capital gains rate, which ranges from 0% to 23.8%, depending on your income.

That's where harvesting can help lower your bill. If you sell an investment at a loss, you can use the loss to offset any gain you might otherwise owe tax on. At first, offsets must be like for like: Use short-term losses to offset short-term gains and long-term losses to offset long-term gains.

Then, any excess losses can be used to offset the opposite kind of gain.

If, after that, your losses still exceed your gains, you can use up to $3,000 of your net loss to negate ordinary taxable income. Any additional negative money you have left over can be rolled over into the following tax year.

Say you started the year with a $10,000 investment that has since declined in value to $8,000. Ideally, that investment will eventually climb back up to $10,000 and beyond. "If you held the entire time 10 to eight and back to 10, you don't have any gains or losses," says Schultz.

But if you sold, and then bought back in at $8,000, you've "harvested" a $2,000 loss while theoretically earning the same return on your investment.

The IRS won't let you do exactly that. The "wash-sale" rule requires you to wait 30 days before reinvesting in whatever you sold — or buying an investment the IRS deems "substantially identical." That means if you sell a particular stock, you'll have to sit tight for a month.

If you bought a fund, however, you can skirt the rule by buying something similar. While you may run afoul of the rule for selling one index fund that tracks the S&P 500 and buying another one, you'd be fine investing in a fund tracking the Russell 1000 — another market index that tracks large-company U.S. stocks.

If you do have a stock or fund you no longer have faith in over the long term, it could also be an opportunity to sell it in favor of a more widely diversified investment, says Adam Nash, co-founder and CEO of Daffy.org and a personal finance lecturer at Stanford University.

Selling a potentially speculative investment in favor of, say, a low-cost index fund can kill two birds with one stone, Nash says. "This move could save you money on your taxes, but at the same time I like strategies that get you to a healthier place for your future."

Investing and tax pros warn that tax-loss harvesting isn't for everyone. Lower income investors (single filers with income less than $41,675 and joint filers under $83,350), for instance, pay a 0% long-term capital gains rate, meaning it makes sense to sell and re-buy winners rather than losers.

It's always a good idea to consult with a financial or tax professional before making any big changes to your portfolio.

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