In any investment portfolio, there are winners and there are losers. Still, there may be a tax-optimized silver lining behind those securities that have dragged down your portfolio performance. It’s a strategy known as tax-loss harvesting.
At its core, tax-loss harvesting aims to minimize the capital gains tax you have to pay on an investment portfolio at the end of the year. It’s a somewhat complicated tax-planning strategy that offsets taxable investment gains with a loss. This is made possible by selling depressed securities within the same tax year.
The great thing is you don’t even need to know all this to opt into the benefits of tax-loss harvesting and potentially lower your investment tax liability. Some robo-advisors and investment apps offer a quick and easy way for you to automatically enroll in a tax-loss harvesting strategy. Non-automated options may also be available through your financial advisor or tax professional.
So, do you want to know why you might say yes when your investment app or financial advisor asks if you want to enroll in tax-loss harvesting? Buckle up and read on.
What is tax-loss harvesting?
Tax-loss harvesting involves selling an underperforming security so you can offset the taxable capital gain of another investment that’s risen in value.
To be clear, this tax-smart strategy only affects non-retirement, taxable accounts. Your 401(k) and IRA most likely fall under a tax-advantaged section of IRS code and therefore you won’t have to pay out to Uncle Sam each year on gains in those accounts.
So what is a capital gain? It’s the money you make from selling an investment for more than you paid. There are two types of capital gains — short term and long term — and they’re taxed differently:
- Short-term capital gains are the earnings from an investment held for one year or less. Short-term capital gains are taxed at your ordinary income tax rate (your tax bracket).
- Long-term capital gains are the profits received from an asset held for longer than a year. The long-term capital gains tax rate is generally lower than the short-term capital gains rate and will usually end up at 0%, 15%, or 20%, depending on your income level and tax filing status.
If you are among the many people who own mutual funds, the decision to sell — or when to sell — the underlying stocks or bonds is made by the portfolio manager, not you. But just as with individual securities, you’ll need to pay any capital gains tax that result from profit-making sales. That’s true whether you take those distributions in cash or have them automatically reinvested in additional shares of the fund. Your mutual fund provider should report any capital gains taxes due at year end on IRS tax from 1099-DIV.
How tax-loss harvesting works
The ultimate goal of tax-loss harvesting is to defer the payment of income taxes to a future date, most preferably to when you’ll be in a lower tax bracket (like during retirement). There will be a larger pool of money left in your portfolio because of fewer taxes taken out, so this tax reduction strategy can let your investment portfolio compound at a faster rate. In short, the tax-loss harvesting strategies can let taxable investment accounts reap some similar advantages to tax-sheltered retirement accounts.
A few other things to know about tax-loss harvesting:
- Investment losses can be used to offset taxable gains or, if you have more losses than gains, up to $3,000 of losses can be deducted against your ordinary income for that year.
- Unused losses can be carried forward and used in future years, indefinitely.
- Because long-term capital gains are taxed at a lower rate than short-term capital gains, there is a preferred sequence to how harvested losses are applied. Long-term losses are applied against long-term gains first, and then against short-term losses. Short-term losses are typically applied against short-term gains.
An example of tax-loss harvesting at work
- Let’s say your taxable investments earned $8,000 in capital gains this year.
- To minimize your tax liability, you sell a poorly performing investment and generate a $4,000 loss.
- You can apply that loss against your gains, ultimately cutting your capital gains tax due in half. Alternatively, you may use the loss to offset $3,000 of taxable income and apply the remaining $1,000 toward the capital gains tax.
A word of warning: it’s possible to run afoul of IRS rules when conducting these types of transactions. The wash sale rule prohibits an investor from claiming the tax benefit if the same or “substantially identical” security is purchased within 30 days of the loss sale.
The following events could void the tax benefits of a tax-loss harvesting strategy:
- You sell shares in a company’s stock and then, within 30 days, repurchase shares of the same stock.
- You sell shares of an S&P 500 index-tracking mutual fund or exchange-traded fund (ETF) and, within 30 days, replace it with a different provider’s S&P 500 index fund.
- One spouse sells a security only to have the remaining spouse repurchase the same security within the 30-day window.
- Within 30 days, you replace a stock from your taxable account with the purchase of the same stock in your IRA or Roth IRA.
At the same time, it’s generally acceptable to reinvest the proceeds from a loss by:
- Replacing shares of one company with another within the same industry, such as a swap of Microsoft stock for Apple
- Selling common stock on one company and replacing it with bonds or preferred stock from the same company (be wary of bonds or preferred stock that may be converted to common stock, though, as this can void tax-loss harvesting benefits)
- Swapping shares of an index fund or ETF for one that tracks a different but highly correlated index: A CRSP U.S. Total Market Index-tracking fund in exchange for one that follows the Dow Jones Broad U.S. Market Index, for example
When rebalancing comes into play
Many investors rebalance their portfolios on a regular basis. This is generally to make sure the desired asset allocation doesn’t drift from its intended course. If one sector or individual stock had a high-performing year, that rebalance could trigger a taxable event. To explain further, let’s look at another example.
Let’s say you own shares of a technology stock, and it’s value has risen dramatically throughout the year. To maintain your desired asset allocation and to avoid a too-heavy weighting in the tech sector, you sell the stock. You receive a $10,000 profit.
At the same time, an energy stock you hold is losing ground. You sell that stock at a $5,000 loss. You can use the $5,000 loss to offset the capital gains tax due on the $10,000 profit.
At the same time, you can use that $5,000 loss to buy shares of a similar but not substantially identical security. In this example, you could purchase a different technology stock, or even a broad-based technology-focused index fund or ETF.
It’s worth noting that tax-loss harvesting is not a beginner-level strategy. Reach out to a tax professional if you’re not confident in your ability to wade through often-unwieldy tax code documents (most of us aren’t!).
An easy way to take advantage of tax-loss harvesting
Although there’s little doubt that this tax savings strategy can be complicated if you try to do it yourself, you can still take advantage of it by tapping into existing, accessible services.
That one small move lets you pass off the lion’s share of the record-tracking, cost-basis analyzing, and investment decision-making to a computer algorithm, which has far greater capacity for daily number crunching than any human possibly could. These services also keep track of and analyze buy-and-sell decisions, which ensures you don’t come into conflict with the wash sale rule.
A good financial advisor or tax advisor can help you manage this strategy with a more traditional brokerage account too, though you may want to ask upfront about associated fees.
FAQs about tax-loss harvesting
Is tax-loss harvesting worth it?
For the right investor, it can be. One study conducted by robo-advisor Wealthfront found that one group of clients added the equivalent of 2.41% of portfolio value — all from clicking “yes” to the tax-loss harvesting option. That’s a number that has the potential to significantly boost earnings, particularly if realized on a consistent, annual basis.
Competitor Betterment, meanwhile, promises no short-term capital gains tax, ever. That’s a perk that could add up to a financial big benefit, over time.
Is tax-loss harvesting a good fit for me?
As with all investment decisions, there is no one-size-fits-all answer. In general, however, tax-loss harvesting best benefits investors who:
- Are investing in a taxable account. Tax-sheltered retirement accounts aren’t hit with the capital gains tax.
- Are in a higher tax bracket. Those in the 10% or 15% tax brackets aren’t generally subject to capital gains taxes.
- Have a long investment horizon. The longer you’re able to kick the capital gains tax can down the road, the more time you’ll have to benefit from potential compound growth within your portfolio.
- Regularly rebalance their portfolio. They therefore recognize investment gains and losses on a regular basis (and it’s a good idea for you to regularly rebalance too).
- Invest money through a robo-advisor platform that offers tax-loss harvesting. Using this kind of platform allows for tax-loss harvesting services free of charge.
Still, some financial professionals warn that tax-loss harvesting is not always an advantageous strategy, particularly for those in a lower tax bracket. Those in a 0% tax bracket may risk triggering a tax increase, but even those in the 15% bracket should beware. The potential for a change to the current tax code always exists, and a future change could increase an investor’s taxes, potentially leaving them with a higher capital gains tax bill.
It’s also worth noting that a tax-loss harvesting strategy should act as a complement — and not a reason — to make major strategy changes to an investment portfolio. In short, don’t harvest losses at the expense of your long-term plan.
What is the maximum amount for tax-loss harvesting?
An investor can typically offset capital gains with capital losses incurred during that same tax year. Losses can also be carried over from a prior year’s tax return. If realized losses exceed realized gains, up to $3,000 of those losses can be deducted from ordinary income, which can further reduce income tax due (or boost a tax refund).
How often can you take advantage of tax-loss harvesting?
Some robo-advisors scour investment portfolios every day looking for tax-loss harvesting opportunities. The frequency of how often you want to take advantage of this tax savings strategy is purely up to you.
The bottom line on tax-loss harvesting
Tax-loss harvesting can act as an attractive component to a well-thought-out, long-term taxable investment strategy, particularly if it’s offered as a free service by a provider you already have an established relationship with.
Consider tax-loss harvesting if:
- It’s fast, easy, and free to implement (such as through a robo-advisor platform)
- You hold taxable accounts (it’s not necessary for your 401(k) or IRA)
- You’re in a higher-tier income tax bracket
As always, reach out to a financial advisor or tax professional if you’re not sure how to accurately and effectively kick off a tax-loss harvesting strategy. Or check the existing benefits of your preferred robo-advisor platform to see whether and how tax-loss harvesting is available for you.
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