Investment returns can result in an added tax burden. Tax-loss harvesting allows you to reduce your investment tax liability by using your investment losses to offset your gains. However, the federal government imposes some restrictions on how tax-loss harvesting can be used, so it’s important to understand the ins and outs before you start implementing this tax strategy.

Understanding tax-loss harvesting

Tax-loss harvesting is an investment strategy that allows you to reduce your taxable investment income by offsetting your capital gains with losses. When you sell any asset for a capital gain, you sell another asset for a loss, thus canceling out your taxable gain.

Tax-loss harvesting can be used with many different investing strategies, but it’s particularly beneficial for high-income investors with high capital gains tax rates and for active traders who have short-term taxable gains and want to reduce the tax implications.

How tax-loss harvesting works

Tax-loss harvesting is a way of rebalancing your portfolio with a particular tax goal in mind. It generally involves two separate transactions: selling one asset for a profit and selling a different asset for a loss. When you sell assets for more than you bought them, you’re liable for capital gains taxes. However, the IRS allows you to offset these losses with capital gains.

For example, suppose you sell one asset for a $1,000 gain. Based on your tax bracket, you would pay 15% in capital gains taxes on that gain. However, if you have another asset in your portfolio that’s currently down $1,000, you could sell that one and use the loss to offset your $1,000 gain. These two transactions essentially cancel each other out for tax purposes, resulting in a $0 tax liability.

In addition to using your capital losses to offset capital gains, the IRS also allows you to deduct losses that exceed your gains by up to $3,000. For example, if you have $1,000 in capital gains, you could claim up to $4,000 in capital losses in a single year, which both offsets your gains and further reduces your taxable income. Any losses that exceed $3,000 can be rolled over to a future tax year.

Read more: How to avoid capital gains tax

When you use a tax-loss harvesting strategy, you can restore your portfolio’s equilibrium by purchasing another asset to replace the one you sold for a loss. However, as we'll discuss later, you’ll have to operate within certain restrictions.

Tax implications and benefits

The most important tax implication and benefit of tax-loss harvesting is that you can reduce your capital gains taxes.

Depending on your taxable income and how long you’ve held an asset before you sold it, your tax rate could range anywhere from 0% to 37%. Unfortunately, those gains can significantly eat into your investment gains. By offsetting your capital gains with losses, you can reduce your capital gains taxes and save yourself money.

Additionally, as discussed previously, tax-loss harvesting can help you offset other taxable income as well. Suppose you had an unusually high taxable income this year and want to avoid a large tax bill. If you have some underperforming assets in your portfolio, you could sell them for a loss and use up to $3,000 of that money to reduce your other taxable income.

Finally, though the primary benefit of tax-loss harvesting is the short-term tax savings, there are also long-term benefits. For each dollar you don’t pay in capital gains taxes, that’s one more that you can reinvest for your future.

Suppose you’re able to use tax-loss harvesting to offset $1,200 per year in capital gains. Assuming you reinvest that money back in the market, after a decade, you’ve been able to reinvest $14,400.

But thanks to market growth, assuming a 10% annual rate of return (the average, according to the Securities and Exchange Commission), that money will have grown to more than $19,000. And the more tax savings you reinvest and the more years you let it grow, the more exponentially that number will grow.

Key tax-loss harvesting rules

Tax-loss harvesting has some major tax benefits, but it also has some specific rules and guidelines you’ll have to follow. It’s important to educate yourself about these rules before you use this strategy to ensure you don’t run afoul of the IRS.

Wash-sale rule

One of the most important rules to be aware of when tax-loss harvesting is the wash-sale rule. This rule prohibits you from deducting your investment losses if you purchase or otherwise acquire a substantially identical security either 30 days before or after the sale.

For example, suppose you have a $1,000 capital gain from your sale of Company ABC’s stock. You also have stock from Company XYZ, which has lost money. You decide to sell your Company XYZ shares for a $1,000 loss to offset your gains from Company ABC’s stock. If you then turn around and immediately repurchase Company XYZ’s stock, you would likely be in violation of the IRS’s wash-sale rule.

Keep in mind that the wash-sale rule doesn’t only apply to securities within one investment account. If you sell Company XYZ’s stock in your taxable brokerage account but then repurchase it in your tax-advantaged retirement account, you could still be in violation of the wash-sale rule.

If you’re considering tax-loss harvesting but also want to replace those assets in your portfolio, it’s important to work with a tax or financial professional to ensure you aren’t violating the rule.

Read more: Wash-sale rule: A key consideration in tax-loss harvesting

Cost basis calculation

The capital gain or loss of an asset is calculated by subtracting your adjusted basis from the sale price. Knowing your adjusted basis is critical for planning your investment strategy, including tax-loss harvesting.

According to the IRS, the basis of an asset is the amount of your investment for tax purposes. In most cases, especially in the case of securities, your adjusted basis is the amount you paid for the asset. For example, if you bought 10 shares of stock for a total of $100, your adjusted basis is likely $100.

However, your adjusted basis could also be higher than the amount you paid for the asset. For example, in the case of stocks and bonds, your adjusted basis could be the amount you paid for the securities, as well as any commissions or fees you paid.

Things can become more complicated when you use a dollar-cost averaging strategy. For example, suppose you buy a few shares of the same company’s stock each month. When you sell the stock, it’s important to know which shares you’re selling to ensure you’re using the correct adjusted basis. In this case, you would typically use a first-in, first-out approach. In other words, the first shares you bought would also be the first you sell, and so on.

When you invest through an online brokerage account, your adjusted basis will most likely be calculated automatically. However, it can still be helpful to track this information on your own to ensure you’re basing your tax liability on the correct numbers.

Example of tax-loss harvesting

To further demonstrate how tax-loss harvesting works, it may be helpful to look at a more in-depth example.

Suppose you have a portfolio of 10 different securities. Stock A is performing well, and you want to sell it to cash in on your gains. However, you don’t want the tax liability that comes with that. However, you have a few other stocks, Stocks B, C, and D, that are down in value.

First, you sell Stock A for a $5,000 capital gain. Then, you sell Stock B for a $1,500 loss, Stock C for a $2,000 loss, and Stock D for a $1,500 loss. Those losses combined equals $5,000, which is enough to offset your $5,000 gain from Stock A. You’re able to enjoy your large profit from Stock A without paying any capital gains taxes.

Once you complete your tax-loss harvest, you want to reinvest the money from your stocks sold for a loss without violating the wash-sale rule. You can achieve this by purchasing a stock that isn’t substantially identical to those you originally sold or purchasing shares in a diversified ETF. You can also decide to wait 30 days and purchase your sold securities, especially if you expect them to rebound.

When to use tax-loss harvesting

When you’re considering whether to use tax-loss harvesting, there are three key factors to keep in mind: the market, your tax bracket, and the type of account you’re investing in.

1. Market conditions: Though tax-loss harvesting can be used during any market conditions, it may be particularly beneficial when the market is down. Not only are you more likely to have assets in your portfolio that are down in price, but you can then repurchase them at a lower price, knowing they are likely to rebound. Keep in mind the wash-sale rule.
2. Tax bracket considerations: Your tax bracket has a major impact on your capital gains tax rate. Just like with your income, the higher your income, the more you’ll pay in capital gains taxes. Therefore, the higher your taxable income and tax bracket, the more beneficial tax-loss harvesting is. On the other hand, tax-loss harvesting isn’t beneficial for those with taxable incomes low enough to fall into the 0% capital gains bracket.
3. Account type: Tax-loss harvesting isn’t necessary for all types of investment accounts. When you invest in a tax-advantaged retirement account like a 401(k) plan or individual retirement account (IRA), you already don’t pay taxes on your capital gains and losses. As a result, this strategy is only necessary when you’re investing in a taxable brokerage account.

Strategies to maximize tax-loss harvesting benefits

When you’re investing, it’s valuable to look for any strategy possible to help reduce your capital gains taxes. Here are a few strategies that can help you maximize your tax-loss harvesting benefits and save the most money on your taxes.

1. Incorporate tax-loss harvesting into a year-round strategy

Some people approach tax-loss harvesting from the approach of calculating their capital gains at the end of the year and then looking for assets they can sell for a loss to offset those gains. But tax-loss harvesting doesn’t have to be something you do just once per year. Instead, you can incorporate this approach into your investment strategy throughout the year, making it easier to sell and purchase assets at the most advantageous time.

2. Choosing the most advantageous cost-basis method

As we mentioned, your brokerage account will often track the order in which you purchase your assets and the cost basis on each asset to make it easy to sell assets on a first-in, first-out basis. However, that’s not the only option.

You can also use an average-cost method, where you calculate your basis as a per-share average cost. One method may be more beneficial than the other for you, but you’ll have to determine that based on your unique situation. A tax professional can help you determine which direction to go.

3. Maintaining long-term goals

It’s important to align your tax savings strategies with your long-term investment objectives. Tax-loss harvesting can benefit your short-term and long-term finances. However, you shouldn’t allow tax savings to overshadow your overall investment goals.

The bottom line

Tax optimization is an important concept beneath the broader umbrella of financial planning. It helps play a pivotal role in your financial wellness. Tax-loss harvesting is just one way of optimizing your tax burden, reducing your capital gains by offsetting them with losses.