Reduce Your Taxes in Retirement by Turning Lemons into Lemonade

Does the current stock market downturn have you on pins and needles?  If so, then you likely have an opportunity to recover a portion of your loss if you act right now. 

While nobody likes to realize a loss on their investments, the great news is you can turn “lemons into lemonade” and recover a portion of any loss if you handle it properly.

One of the areas where proper planning can help is tax loss harvesting, i.e. utilizing any unrealized losses or unused capital losses that you have realized in prior years (and potentially this year), to reduce your income tax burden each year. 

Let’s quickly review capital gains tax law for a moment so we can clarify where this opportunity lies for you.

Capital Gains Tax Law and How to Save Money in Taxes

For investments you currently own outside of IRAs and 401(k)s (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $100,000 and later sold all of it for $175,000, you would owe capital gains taxes on the growth, i.e. $75,000.

On the flip side, however, if you purchased a stock or stock fund for $100,000 and, after temporarily falling out of favor, you sold all of it for $75,000, you can declare a capital loss of $25,000.

That $25,000 capital loss, while painful to realize, has significant value if handled properly.  For example:

  1. You may use it to offset $25,000 of capital gains you realized in the same year, thus eliminating taxes on $25,000 of capital gains.  This saves the average taxpayer a minimum of $3,750 in federal taxes, not to mention state taxes.
  2. If you don’t have $25,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year.  That would save the average taxpayer approximately $750.
  3. You can then carry the unused portion ($22,000) over to next year and continue the same strategy.  If you have a $22,000 gain next year, you can offset the entire tax due.  If not, you can offset another $3,000 of ordinary income tax and carry the remaining $19,000 over to the following year.

Your Tax Saving Opportunity

If you sold any investments in the past, thus “realizing” a capital loss, you now have the opportunity to put those losses to use offsetting realized gains this year.

Or, if you have any investments today held outside of IRAs where your cost basis (what you paid for the investment) is higher than the current market value due to the recent stock market downturn, you have an opportunity to lock in a capital loss right now and use it against your realized gains this year. 

Your Tax Saving Strategy

My recommendation for you is three-fold:

  1. Review your most recent federal income tax return.  Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into this year.  And, if so, how much?
  2. Determine if you have any realized gains in your non-IRA accounts so far this year: 
    • Have you sold any of your holdings at a gain, thus already realizing gains that you may want to potentially offset?
    • If you own actively managed stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates.  Do your best to determine what your short and long-term gains will look like.
    • Do you have any stocks or stock funds that you have thought about selling, but you haven’t pulled the trigger because it will carry a large capital gains tax with it? 
  3. Take a look at your unrealized gain/loss positions on your non-IRA account statements:
    • Is the cost basis (what you paid for the investment) for any of your holdings greater than the current market value?  If so, this may be due to three situations:
      • The share price is lower today than when you purchased the fund due to market forces, or
      • The share price is lower today because your fund declared capital gain distributions in the past and you have already paid tax on them, thus raising your cost basis above what you paid for the investment, or
      • You have been reinvesting the dividends from your fund to purchase more shares over the years, thus raising your cost basis.
    • If this is true for any of your holdings, you have an opportunity to “realize” a capital loss before year-end (tax loss harvesting) and offset any of your realized gains.

Once you’re armed with this information, look for opportunities to offset this year’s gains with prior losses you’ve carried forward, or with losses you could “realize” this year by selling specific holdings at a loss, and replacing them instantly with substantially similar investment holdings adhering to the “wash sale rule.”

This is a discipline and exercise we continue to go through for our Relaxing Retirement members each year, especially during temporary market downturns like we’re experiencing right now, and at year-end.   

If you haven’t done so already, take a moment to explore harvesting opportunities right now. 

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