What is Tax-Loss Harvesting, Is It Legal, and Does It Build Wealth?

According to this Charles Schwab resource, tax loss harvesting is when you offset capital gains with capital losses, but what exactly does that mean? We promise it’s not that complicated. Tax-loss harvesting might sound a bit intimidating, but don’t worry—it’s actually a simple and legal strategy that can help you build wealth over time.

Whether you’re running your own business, juggling family life, or managing your household’s money, you’ve probably felt overwhelmed by financial jargon before. You’re not alone! We’re here to break it down in a way that makes sense, so you can feel empowered and confident about your money decisions. By the end of this article, you’ll understand exactly what the tax-loss harvesting strategy is, how it works, and how it can help you grow your wealth—without all the complicated terms. Let’s get into it!

So, What Exactly is Tax-Loss Harvesting?

Tax-loss harvesting is a straightforward tax savings strategy that allows you to sell investments that have gone down in value, and then use those losses to offset the taxes you owe on other investments that have made a profit.

It might sound complicated, but it’s really just a way of balancing your financial losses with your gains to reduce your overall tax bill. You’re essentially making the most out of a not-so-great situation by using your losses to your advantage.

Why It Matters

Why should you care about tax-loss harvesting? Because it can save you real money on your taxes. Every dollar you don’t have to pay in taxes is a dollar you get to keep—and who doesn’t want that?

This tax strategy allows you to make your money work smarter for you, especially in years when your investments may not have performed as well as you’d hoped or your ordinary income took a dive. Basically, tax loss harvesting involves keeping more of what you’ve earned and making sure that your money is being used as efficiently as possible.

What does that look like? Well, imagine you bought some stock last year, but unfortunately, it didn’t do well and lost value. Rather than just feeling frustrated and holding onto it, you can sell that stock and use the loss to reduce the taxes you owe on other investments that did make money.

Let’s say you have another stock that did great—tax-loss harvesting lets you pair the bad with the good and lower your tax bill in the process. This “tax break” is like turning lemons into lemonade, financially speaking!

A Few Key Terms to Know Before We Continue…

Before we delve deeper into tax loss harvesting, let’s a few key financial terms with which you might not be familiar. Chances are, you’ve heard these terms in casual conversation, on the news, or even at work, but you might not know the strict definitions. Let’s take a look.

Taxable Income

Taxable income is basically the amount of money you make that the government taxes. It’s your income minus any deductions or exemptions you qualify for. When you use tax-loss harvesting, you’re trying to lower this amount by reducing the taxes you owe on your investment gains, which helps keep more money in your pocket.

Capital Gains

Capital gains happen when you sell something (like a stock or an investment) for more than you paid for it—this is your profit. Depending on the asset, these might add to your tax liability. But here’s where it gets a bit tricky: there are two types of capital gains, and they’re taxed differently.

• Short-Term Capital Gains: If you sell something after holding it for one year or less, it’s considered a short-term capital gain. The capital gains tax on short-term gains is equal to your regular income tax rate (which means they can be taxed at a higher rate than long-term gains).
• Long-Term Capital Gains: If you hold an investment for more than a year before selling it, it’s a long-term gain. Long-term gains usually get taxed at a lower rate, which is great news for you!

Capital Losses

If you sell an investment for less than what you paid for it, that’s a capital loss. No one likes losing money, but here’s the silver lining: you can use these losses to reduce the taxes you owe on your gains. Tax-loss harvesting is all about turning those losses into a financial advantage.

Wash Sale Rule

This is a rule to watch out for when you’re doing tax-loss harvesting. The wash sale rule says you can’t sell an investment at a loss and then buy the exact same investment (or something very similar) within 30 days. If you do, you can’t use that loss to reduce your taxes. So, be mindful of this timing when using the strategy.

Offsetting Capital Gains and Losses

This is the process of balancing out your wins and losses. If you made a profit on one investment but lost money on another, you can use that loss to reduce the amount of tax you owe on your profitable investment. It’s a way to lower your overall tax bill, helping you keep more of what you earned.

Is Tax-Loss Harvesting Legal?

The short answer? Yes, tax-loss harvesting is completely legal! It might sound like some complicated financial trick that might draw unwanted attention from the Internal Revenue Service (IRS), but it’s a totally legitimate strategy that many people—regular investors and financial professionals alike—use to reduce their taxes. There’s nothing sneaky or questionable about it.

Tax-loss harvesting is a widely recognized and IRS-approved strategy. The IRS allows you to sell investments at a loss and use those losses to offset your capital gains, which lowers the taxes you owe. As long as you follow the rules (like the wash sale rule), it’s a perfectly fine way to minimize your tax bill. It’s been used for years by people looking to make the most of their investments, and you can too!

What If I’m Worried About Doing This Legally?

If you’re feeling cautious or even a little skeptical, that’s totally normal! When it comes to anything involving taxes, we all want to make sure we’re staying on the right side of the law.

But rest assured, tax-loss harvesting is a straightforward, above-board tactic that everyday investors use to their advantage. You don’t need to be a financial expert to benefit from it, and you won’t be doing anything shady. Think of it as a smart way to make your money work for you!

How Does Tax-Loss Harvesting Work?

Tax loss harvesting might sound like a lot to manage, but don’t worry—you don’t have to figure it all out on your own. Many financial advisors or even robo-advisors can handle tax-loss harvesting for you automatically. They’ll make sure it’s done right, saving you both time and stress! If you do want to do this yourself, read on for our step-by-step breakdown of the process.

Step 1: Identify Your Losing Investments

The first step in tax-loss harvesting is simple: take a look at your portfolio and see which investments have lost value. These are the ones you’ll want to focus on. Don’t think of them as failures—instead, see them as opportunities to turn those losses into something that works in your favor.

Step 2: Sell the Losing Investments

Once you’ve identified those underperforming investments, you’ll sell them. This is called “harvesting” the loss. By selling, you’re locking in the loss, which may sound counterintuitive, but it’s actually the key to reducing your tax bill.

Step 3: Use the Loss to Offset Gains

Now, here’s where the magic happens. The losses you harvested can be used to offset the gains you’ve made on other investments. Essentially, the loss cancels out some or all of the taxes you’d owe on your profitable investments, lowering your overall tax bill.

Step 4: Reinvest in Similar Assets

You don’t have to walk away from investing after selling. The next step is reinvesting in similar assets to stay in the market. Just make sure you follow the “wash sale rule,” which means you can’t buy back the exact same investment within 30 days. But you can find similar ones to stay on track with your goals.

How Can Tax-Loss Harvesting Build Wealth Over Time?

The less money you’re paying in taxes, the more you have left to reinvest. Over time, this means more money working for you, allowing your investments to grow. It’s all about making sure that you’re keeping as much of what you’ve earned as possible.

By consistently harvesting your losses year after year, your portfolio has a better chance to grow faster. The savings from your reduced tax bills compound over time, creating more wealth in the long run. Think of it like getting a little bonus every year that helps boost your investments.

When the market takes a hit, most people feel stressed or anxious. But with tax-loss harvesting, those downturns can actually work in your favor. You can use the losses to reduce your taxes, turning a challenging time into a long-term opportunity for growth.

Actionable Steps to Get Started

Tax-loss harvesting might sound complicated, but you don’t need to be a financial guru to take advantage of it. To get started, review your portfolio, consult with professionals, automate the process, and stay consistent.

First, take some time to review your current investments. Identify any that have lost value—these are the ones you can sell to harvest the loss. If you’re not sure, a financial advisor can help with this step. A financial advisor can walk you through the process, making sure you maximize your tax savings while staying within IRS rules.

Many investment platforms and robo-advisors can automatically handle tax-loss harvesting for you. This takes the pressure off, letting you focus on other things while still benefiting from this smart strategy. Last but not least, be consistent! Make tax-loss harvesting part of your regular investment routine. It’s not a one-time thing—by doing it consistently, especially during market downturns, you can continually reduce your tax bill and grow your wealth over time.

Final Thoughts on the Tax Loss Harvesting Strategy

To review, tax-loss harvesting is a completely legal and surprisingly simple strategy that can help you save on taxes and grow your wealth over time. By making smart use of your investment losses, you can lower your tax bill and put more money back into your portfolio for the future. It’s all about using every tool at your disposal to build a solid financial foundation.

Don’t let financial jargon or complex-sounding terms intimidate you. Tax-loss harvesting is a strategy that anyone can use, regardless of your financial expertise. Every small step you take toward understanding and managing your finances is a step toward long-term financial freedom and security. You’ve got this!

Your Next Steps

Now that you understand how tax-loss harvesting works, take the next step by reviewing your investments or talking to a financial advisor. They can help you determine if this strategy is right for you and get you started on the path to greater wealth and tax savings. Why not start today?

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