While this move closes out one of my “10% Trade” holdings for a loss, I think it was a perfect opportunity for tax-loss harvesting.
Tax-loss harvesting is a strategy that involves selling an investment at a loss in order to reduce your tax bill.
While I won’t get into all the specifics behind my particular tax situation, I will talk about this Mattel trade in a “big picture” hypothetical scenario that I think helps illustrate the power of tax-loss harvesting. Especially when it’s combined with making a tax deductible contribution to a tax-deferred retirement account, like a 401(k).
Specifically, I’ll show you how it’s possible to turn my $2,292 loss with Mattel into tax savings of $3,108 (28% tax bracket)… $3,663 (33% tax bracket)… $3,885 (35% tax bracket)… or even $4,395 (39.6% tax bracket).
I realize this sounds outrageous, but I’ll explain how this could work in a moment.
Depending on your own situation, you may want to consider a similar tax-saving strategy for yourself. Just be sure to talk to your accountant or a tax advisor before taking any action because 1) everyone’s situation is unique and 2) I’m not a tax expert.
That said, here’s the situation…
Back in July, as the result of this “10% Trade”, I bought 300 shares of MAT for $37.00 per share. Yesterday, I sold those same 300 shares for $29.36 per share. So I invested $11,100 and only received $8,808 back… a loss of $2,292.
Now, my loss wasn’t really $2,292 because I collected $360 in options premium and $228 in qualified dividend income while I owned Mattel… and it’s critical I account for this income when doing my taxes. However, for the purpose of this article, let’s disregard this income. I don’t want things to get too confusing.
Step 1: Tax-Loss Harvesting Offers Tax Savings of Up to $907.63
So let’s assume I didn’t collect any income from my shares and I simply lost $2,292 on this trade. I’m now out $2,292… now what?
Here’s the thing: I can deduct this $2,292 from my 2014 taxable income. In other words, this is $2,292 that I won’t have to pay taxes on.
Take a look at the following table. Depending on my tax bracket, selling MAT for a $2,292 loss could result in tax savings of between $229 and $907…
Do you see why I say everyone’s situation is different? It’s obviously a lot more compelling to take a loss like this when you’re in a higher tax bracket, as the tax savings become significantly higher.
But wait, it gets better…
Step 2: Contributing the Proceeds of the MAT Sale to a Tax-Deferred Account Offers Tax Savings of Up to $3,487.97
Since I sold my MAT shares, I now have $8,808 in “fresh” capital to put to work. Instead of keeping this cash in my taxable brokerage account, I could contribute this money to my tax-deferred, self-employed 401(k) and reduce my 2014 taxable income even further.
Of course, I’ve already paid taxes on this specific chunk of money, as these trades took place in my after-tax/taxable brokerage account. In addition, I’ll need to pay taxes on it again when I start taking distributions from my 401(k) in the future. But at that point, I’m fairly confident I’ll be in a lower tax bracket than I am today. That’s why I’m ok “kicking the can down the road” — I’m ok paying taxes in the future in order to get a tax deduction now. After all, if for some reason I don’t end up being in a lower tax bracket during retirement, I suppose it will be a good problem to have.
Again, depending on my tax bracket, contributing this $8,808 to my 401(k) could result in additional tax savings of between $880 and $3,487. Take a look…
Now let’s add up all the potential tax savings between “Step 1” and “Step 2″…
As you can see, combining a tax-loss harvesting move with a tax deductible contribution to a tax-deferred retirement account, makes it possible to turn my $2,292 loss with Mattel into tax savings of $3,108 (28% tax bracket)… $3,663 (33% tax bracket)… $3,885 (35% tax bracket)… or even $4,395 (39.6% tax bracket).
Important: Again, I’m not a tax expert and the purpose of the ideas I’ve outlined above are simply to give you something to think about and to help illustrate the potential of a tax-loss harvesting strategy. There are several more factors to consider that I didn’t get into (like whether your sale would be classified as a short-term or long-term capital loss, any wash-sale implications, any options premiums you collected, any dividend income you collected, your total capital losses/gains for the year, your eligibility and the amount you can contribute to a tax-deferred account like a 401(k), if you expect to be in a lower or higher tax bracket when it comes time to take distributions from your tax-deferred account, etc.).
With this in mind, before you take any tax-loss harvesting moves or tax deductible contributions on your own, I urge you to run any questions by your accountant or tax advisor.