Taxes aren't on the top of most people's minds, especially at this time of year. Yet those who take advantage of certain money-saving tax strategies before others even start thinking about them can get a valuable head start over their peers.
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One strategy that gets popular toward the end of the year involves selling stocks that have gone down in value since you bought them. Known as tax loss harvesting, this strategy is technically available until the last day of the calendar year. But there are some reasons why using tax loss harvesting earlier can offer advantages over waiting until the last minute.
How tax loss harvesting works
The U.S. tax system provides for taxpayers to claim capital gains and losses when they sell an investment. In general, if the value of the investment has gone up since you bought it, you'll have a capital gain. If it has gone down, then you'll have a capital loss.
If you have both gains and losses, then you're allowed to offset the capital gain on your profitable investments with capital losses on your less successful investments. In addition, if you have more losses than you need to offset your gains, then you can use up to $3,000 per year of those losses to offset other types of income, such as interest or dividend income or even wages and salaries.
Why waiting can cost you
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Most investors are reluctant to sell off losing positions, hoping that they'll rebound and keep them from having to lock in their loss. That's one reason why so many people use tax loss harvesting only in the last several weeks of the year. Combined with the general reluctance to deal with taxes before it's absolutely necessary, you'll typically see a big pick-up in tax loss harvesting activity in the weeks leading up to Dec. 31.
The problem with waiting is that market participants know which stocks have fallen in value and can anticipate the ones that are likely to see tax loss harvesting activity. The increased selling pressure often results in further share price declines, because the buyers on the other side of the transaction know that the sales are motivated by the desire to lock in tax benefits. That's why losing stocks often perform even worse in December, only later gaining back ground in subsequent months.
Staying ahead of the game
If you harvesting your tax losses before the end of the year, you can avoid some of these issues. Specifically, if you sell now, then you'll get in before the stronger selling pressure from other investors picks up and hurts share prices. Early sellers typically get higher prices when they sell than late sellers.
Markets have also been hitting new record highs on a regular basis for months. Selling now also has the advantage of avoiding the risk of a stock market reversal that could push stocks downward more broadly.
If you play your cards right, harvesting tax losses now could even let you take advantage of other tax loss harvesters later. Say you want to claim a tax loss but actually still like the stock for the long term. Tax provisions called the wash sale rules force you to wait 30 days to buy back a stock after you've sold it for a loss. Those who wait until year-end to sell can't buy back their shares until late January, often missing out on beginning-of-year stock market rallies. Sell now and you can buy back just at the time that most people are selling -- giving you the leverage to command more favorable prices.
Don't miss out on a great tax break
Losing money on investments isn't fun, but tax loss harvesting gives you at least some benefit to compensate for your losses. If you avoid procrastination, tax loss harvesting will be more effective for you.
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