Editor’s Note: The end of the calendar year is when many investors execute trades in taxable accounts for tax purposes. To reduce capital gains taxes, they sell underwater positions to realize losses to offset realized gains. If doing so can put you into a lower tax bracket, loss harvesting can make quite a bit of a difference in the amount of taxes you have to pay. Here’s how this strategy works.

If you have a net capital loss for the year, you can offset it against your other income for a maximum of $3,000 reduction per year. Any losses over $3,000 can be carried over to future years.

Capital gains are separated into long-term (LT) and short-term (ST) gains. Gains on assets held for more than one year is considered long term. Gains on assets held for one year or less is considered short term.

Note that the tax rates on qualified dividends are the same as the rates for LT gains and the tax rates on non-qualified dividends are the same as the rates for ST gains.

Capital Gains vs. Dividends

For those new to investing, capital gains are when you realize a profit by selling something at a higher price than when you bought it. Dividends, on the other hand, are regular payments, typically out of profits, corporations pay out to shareholders. Thus, if you sold some options, even though the cash inflow acts like a dividend, the profits you realize would be considered a ST gain (unless you wrote a long-dated option and held the position for more than a year, in which case it would be a LT gain).

LT gains are taxed at rates of 0%, 15%, or 20%, depending on your tax bracket while ST gains are taxed at your ordinary income tax rate, which could be 10%, 12%, 22%, 24%, 32%, 35% or 37%, again depending on your bracket.

In order to qualify for the 20% LT gains tax bracket—the highest possible—you would need to be making more than $459,750 if you are single or more than $517,200 if joint filing as a married couple. But on the ST side, if your taxable income is between $41,776 to $89,075 (single) or $83,551 to $178,150 (married, joint filing), you would already be in the 22% bracket. Thus, LT capital gains taxes are clearly more favorable to the investor. (See the below table for ST capital gains tax rates, based on IRS information.)

The IRS requires that the LT losses to offset LT gains and ST losses to offset ST gains first. And if there is any net loss left over, then it can be used to offset gains in the other category.

For example, if you have $8,000 in ST gains and $10,000 in short term losses, the $2,000 net loss can then be used to lower whatever LT gains you have.

Beware of the Wash Sale Rule

If you like the stocks you are taking losses on, you can always buy back the stocks at a later date. Just be careful to wait more than 30 days to buy back that stock, or you will trigger the wash sale rule and won’t be able to claim a deduction on the loss.

The IRS says that you cannot buy the same or a substantially identical security within 30 calendar days before or after selling a security for a loss.

The restriction of not buying the same security within 30 days after the sale is self-explanatory but the before restriction may need a little clarification. For example, if you have unrealized losses on 50 shares of AAPL, and you buy another 25 shares of AAPL. Then three weeks later you decide to sell your original 50-share lot at a loss. This will trigger the wash sale rule and you won’t be able to claim a loss deduction.

This doesn’t mean that you will lose the deduction forever, it just means you will have to wait until you sell later on (and not violate the wash sale rule) to claim the loss, if the position is still a losing one.

Lastly, if you plan to harvest losses this year, be sure to sell stocks by December 28. The final business day of 2022 is December 30. Since stock trades take two days to settle, if you sell a stock after December 28, the trade will settle in 2023 and you won’t be able to claim the loss for this year. For mutual funds, settlement is usually one day.

The Jim Fink Method…

Let’s put aside the topic of losses, and focus now on gains.

There’s a way to beat the market, in bear or bull conditions. That’s where our colleague Jim Fink comes in.

Jim Fink is the chief investment strategist of Options For Income, Velocity Trader, and Jim Fink’s Inner Circle.

Jim’s investment methods have enabled him to take his life’s savings of $50,000, turn the amount into $5 million, and retire early at age 37.

Jim Fink has been sharing his trading secrets for over a decade. Click here to learn more.