How to Legally Reduce Your Taxes

October 2, 2021

How to Legally Reduce Your Taxes

The world of finances is complex, and it's nearly impossible to figure out where the money you pay in taxes actually goes.

Do you know if your income tax dollars are going toward a worthy cause or being wasted?

Well, maybe someday we'll have a functioning government that actually functions, but until then, if you find yourself feeling frustrated with how much of your hard-earned cash is going straight to Uncle Sam each year—and especially if you have some capital gains outside of your 401(k) or traditional IRA account—you may be interested in something called a "tax-loss harvesting."

Here's what it means, why it could save you thousands every year, and whether it's right for your wallet.

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A Tax Loophole …

"Tax-loss harvesting," also known as "tax loss selling," is a fancy (and kind of complicated) term for selling an investment that has dropped in value in order to avoid future capital gains taxes on it.

For example, say you bought shares of Company Y for $10,000 years ago and they've grown to be worth $15,000 over time. But this year the stock market has been a bit rocky and your shares have fallen to being valued at only $12,000—and the drop means you're going to have to pay a capital gains tax if you sell them now.

Well, you can get rid of those pesky Company Y shares without worrying about that capital gains tax by just selling them.

And just like that, you've "harvested" a $2,000 "tax loss."

You can then use that $2,000 to offset other capital gains and don't have to pay any taxes on it. So essentially you get to keep your gains without having to pay anything.

But There's a Catch …

If this sounds too good to be true, that's because it probably is. For starters, harvesting or selling your investments could actually cost you money in fees and commissions.

Also, if you plan on keeping these Company Y shares for the long term (in other words: not trading them for another stock anytime soon), they will eventually rebound and go back above $10,000—meaning you'll basically lose out on thousands of dollars you could have made if you had just left your shares alone.

Finally, if you're thinking that harvesting or selling is a smart way to invest more money in something else that's not losing value, think again: If the price of Company Y picks back up after you sell, they might go up higher than $15,000—and now by selling them for only $12,000, you've officially missed out on even more cash.

But Wait …

While it may be complicated and risky to harvest your investments, what if there were an easier way to make this strategy work—to avoid all those expensive commissions and fees? Well, there is!

A Better Way …

You can legally lower your tax bill simply by using a Roth IRA or 401(k) to buy those Company Y shares that have been plummeting in value.

Individuals who have access to a Roth IRA can avoid paying capital gains tax if they withdraw their investments out of the account and then use that money to purchase Company Y shares (even though there will be no deduction for the transaction).

If you happen to be investing through your employer's retirement plan, like a 401(k), there are also ways around the capital gains taxes.

But there's a downside: The maximum amount of IRA contributions anyone can make each year is $6,000 (or $7,000 if you're 50 or older) or 100% of your earnings, whichever number is smaller. And the deadline for making these IRA contributions has already passed (on May 17th) for 2021, so this strategy is only available if you have an existing IRA account and you didn't contribute during the off-season.

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Back Door IRA Contributions...

A back door IRA contribution is a way for an investor to make a contribution to an Individual Retirement Arrangement (IRA), such as a Traditional or Roth IRA, when the individual does not meet the ordinary income limits set by the Internal Revenue Service (IRS).

A back door IRA can be used in cases where you don't have enough earned income to contribute directly to a tax-deductible traditional IRA and/or you can't contribute directly to a Roth IRA. This type of arrangement is sometimes referred to as making an indirect or non-taxable contribution.

How Back Door Contributions Work

To do so requires using what's known as a "backdoor" strategy which involves making contributions through investments rather than direct contributions to IRA plans. It is possible to contribute directly to a Roth IRA, but income limits apply.

A back door contribution allows you to contribute money into your IRA, which you can then later take out tax-free since the withdrawal will be considered an early distribution; these are reported on IRS Form 5329.IRS Form 5329.

Funds are withdrawn from an IRA before age 59 1/2 may be subject to additional taxes and penalties (except for certain exceptions). See IRS Topic 554 Learning about distributions (early withdrawals) for more information.

If you have both types of IRAs, it's possible that if one isn't large enough at first, the other might become too large over time as you incur further taxable income.

In other words, harvesting investments isn't right for everyone. But if it sounds like something worth considering, finding ways around the capital gains tax could be a great way to make the most of your investment losses.

Disclaimer: This is not investment advice, just commentary.  Always do your own research and consult with a licensed financial advisor when making any type of investment.

About the author 

Jenna Lofton, the founder of StockHitter.com, has been actively trading stocks and investing for nearly 11 years.

She holds an MBA in Finance, and another in Business Administration, and lives in Staten Island, NY.

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