It's that time of year again, when we decorate the tree, light the menorah, and savor the time spent with family and friends.
Oh yeah -- it's also a time to consider the taxes you may owe in April. Talk about holiday fun!
No one especially likes paying more taxes than they should. While there are many ways you can save on your taxes, such as itemizing deductions if you own a business, making charitable contributions, or even purchasing an electric vehicle, making moves in your investment portfolio towards the end of the year can also yield hefty savings. Don't miss out on these two tax-lowering investing moves… even though each comes with several caveats.
1. Harvest your losses
One of the most straightforward ways to lower your tax bill is to harvest investment losses in taxable investment accounts.
If you have a stock that is down from its highs, if you sell it before the end of the year, you can realize that loss to offset any other realized capital gains for the year. And if you don't have any capital gains for the year, you can use investment losses to offset up to $3,000 in income. Any excess losses over $3,000 can then be carried over into the next year, allowing you to offset gains and/or income from future years.
Therefore, if you are sitting on unrealized investment losses today on certain positions, there's still time to take losses on those stocks to offset your tax bill before December 31.
But mind a "wash sale"
However, just because you have investment losses doesn't mean you should take them. In particular, if it is stock in which you have high conviction and may want to buy back in the short-term, the wash sale rule may get in the way of your plan.
A wash sale is when you buy back a stock within 30 days of selling it for a loss. Under current rules, buying a stock within the 30 days after a sale negates the tax loss. Instead, that loss will be applied in the future when you sell the stock again.
For instance, if you sell a stock for a $10 loss on Christmas but buy it back on January 15, you won't be able to deduct the $10 from your 2024 capital gains or income. Instead, that $10 will be added to the your cost basis in the stock, delaying the tax benefits to future years.
The wash sale rule also applies to selling different tax lots. What is a tax "lot?" Let's say you have "averaged down" on a stock, buying a share at $100 and then again after a 50% drop to $50. The stock has since bounced back to $75.
Under current rules, you are able to specify that you are selling the share you bought at $100, thereby realizing a $25 loss, not a $25 gain.
Sounds great, right? But there is a condition. You can't have bought the stock at $50 within 30 days of selling the $75 stock, even if it was in the past, and not the future. That would be another wash sale. So, you can think of the wash sale rule as buying 30 days before or after a sale, with the day of the sale included, making for 61 days.
Also, don't think you can get "cute" by selling a stock for a loss, then buying call options on a stock to maintain your upside exposure. The wash sale rule states that if you cannot buy any security that is "substantially identical" to the one you just sold. That definition can get somewhat fuzzy at times, but going long call options on the same stock you just sold would definitely be a "substantially identical" purchase.
Image source: Getty Images.
Downsides to tax-loss selling and how to mitigate them
While realizing losses can help lower one's tax bill, you should think carefully before making any sale. After all, if you have a high conviction in a stock for the long-term, you could miss out on a big gain in the span of just 30 days.
This is especially true this time of year, as the last week of the year and first week of January often see gains in the market, a phenomenon known as the Santa Claus rally.
Still, there are a couple strategies you could also employ to minimize the risk of tax-loss selling a position about which you are optimistic.
This includes buying a different stock with similar characteristics to the one you just sold – likely, a competitor in the same industry. So, for instance, if you take a loss on Coca-Cola, you can buy Pepsi stock and hold for 31 days, before switching back to Coke, if you still like Coke better over the long-term.
Another way around missing out on a potential gain is to sell your stock and then buy an exchange-traded fund that holds a basket of stocks in the same industry sector. For instance, you could take a loss on a large technology stock, but then buy the Invesco QQQ Trust (QQQ 1.81%), a technology index, and hold that ETF for 30 days, before switching back.
It's highly unlikely that a stock or ETF in a similar industry would move significantly differently than your original stock over a span of 30 days, as long as there aren't major events in that span, such as earnings releases. But of course, anything can happen.
2. Max out your traditional IRA or 401k
Another way to lower your tax bill at the end of the year is to max out your contribution to a tax-deferred account such as a traditional IRA or 401k.
You actually have until April 15 of 2025 to make an IRA contribution for the 2024 year, up to a $7,000 limit or $8,000 limit for those over 50. However, contributions to 401(k) or 403(b) plans are cut off at December 31. The max contributions are $23,000 for a 401(k) or 403(b) plan, but $30,500 if you are 50 or older.
These contributions can make a big difference to your long-term returns, as IRA and 401k plans are deductible from today's taxes, and grow in a tax-deferred manner until you withdraw the funds in retirement.
But as with tax loss harvesting, there are caveats to contributing to tax-deferred retirement plans, based on your particular situation. If you think you may need access to those funds before you turn 59.5 years old, keep in mind there is a 10% penalty for withdrawing early, in addition to the funds being added to your gross taxable income upon withdrawal.
Also, don't try to get cute by selling a stock for a realized loss in a taxable account, and then buying the same stock in your tax-deferred IRA account at the same time, thinking you can harvest the tax loss. That counts a wash sale, even if the sale and buy happen in separate accounts!
So to sum up: maxing out contributions to a tax-deferred account while harvesting tax losses in a taxable account can greatly lower your April tax bill -- as long as you're not buying or selling the same stock.
