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Monday, April 15, 2024

What is tax-loss harvesting?

How tax-loss harvesting can reduce your tax bill 


Tax-loss harvesting is the investing technique of selling depreciated securities to offset gains within a given tax year.

This investment strategy can help lower your overall tax bill since your tax is paid on the net amount. The cumulative tax savings can make a real difference in your life, whether that means retiring earlier, helping your kids pay for college, or leaving behind a larger legacy.

What is tax-loss harvesting?

The concept of tax-loss harvesting is slightly counterintuitive—after all, you’re supposed to sell high, right? But the idea is not to eliminate exposure entirely. It can function as a temporary sale to reduce your tax bill, after which, if you want to, you can buy back the same stock following a 30-day waiting period.

Even if you don’t have any gains to offset, the IRS allows you to deduct up to $3,000 in capital losses from your ordinary income each year. Also, you can carry the losses over to subsequent years until they’re exhausted. So, for example, if you lose $15,000 in one year, you have five years of IRS deductions that can offset gains or add to the loss carryover.

So capital losses are first used to offset capital gains, and if capital losses exceed capital gains, you can offset up to $3,000 of other taxable income per year. The end result is a helpful tax benefit: a potentially higher net after-tax return and a well-balanced portfolio.

How does tax-loss harvesting work?

A portfolio of stocks is likely to have both winners and losers in any given year. If left untouched, this can lead to material portfolio deviations where the changes in value in individual securities cause the portfolio to become imbalanced.

Tax-loss harvesting creates an opportunity to rebalance the portfolio back to model weight—you can claim losses and simultaneously pare down winners with large, embedded gains.

Example of tax-loss harvesting

A hypothetical investor owns 10 securities in his portfolio. Three of them have currently lost value: Stock A, which is down 10%; stock B, which is down 7%; and stock C, which is down 4%. The remaining stocks are currently higher than when he bought them.

Utilizing tax-loss harvesting, the investor could sell stocks A, B and C in order to realize those losses, which he could then use to offset the gains from the stock winners. He could then purchase shares in a diversified exchange-traded-fund, or ETF, in order to stay invested for at least 30 days and avoid the wash-sale rule (see below). After the 30 days are up, he can repurchase the same securities he sold if he believes they will rebound in value.

Keep in mind that tax harvesting tends to work best when you own individual securities, like stocks and bonds. Mutual funds don’t give you the opportunity to strategically sell positions. The benefits of risk reduction and tax avoidance can justify the unknown benefit of hoping for a rebound in the stock that is down.

When to use tax-loss harvesting

Let’s say you sold a security for a capital gain. You might sell another security at a loss to turn your unrealized loss into a realized loss. Doing so would reduce your net capital gains, and therefore, reduce the capital gains taxes you’ll owe.

Following are a few guidelines for when to consider implementing tax-loss harvesting.

  • When the markets are down: This may offer the greatest opportunity to buy replacement securities at low prices.
  • If you are in a high tax bracket: You can potentially realize the greatest tax savings. Single individuals with less than $40,400 in annual income, or married couples filing jointly who make less than $80,800 per year, don’t owe any capital gains tax so the strategy won’t help them.
  • If you have a brokerage account: Tax-loss harvesting is only used with securities held in taxable investment accounts, not retirement accounts.

Strategies to maximize tax-loss harvesting benefits

  • Incorporate tax-loss harvesting into your year-round strategy. Traditionally, investors consider selling assets in taxable (i.e., non-retirement) accounts that have losses at the end of the year.
  • Choose the most advantageous cost-basis method for your investments. You can consult with a financial professional to help determine your tax strategy.
  • Keep sight of your long-term goals. If you choose to implement tax-loss harvesting, be sure to keep in mind that tax savings should not undermine your investing goals. Ultimately, a balanced strategy and periodic reevaluation can help align your investments with your objectives.

Key tax-loss harvesting rules

As you execute on tax-loss harvesting, keep a few thoughts in mind.

Wash sale rule

Referenced earlier, the wash sale rule states that you cannot purchase the same security within 30 days before or after the sale and claim the loss. If you do so, your loss would most likely be deferred until the security is completely sold.

Note that you also can’t buy a new security that is “substantially identical.” For instance, if you sold an S&P 500 Index ETF to claim a loss, you can’t turn around and buy a new S&P 500 Index ETF from a different provider inside of 30 days.

However, if you sold a handful of stocks, you could buy a broad-market equity ETF in their place. You would then hold it for 30 days to maintain stock exposure and avoid the wash sale rule.

The wash sale rule gets really complicated when a loss occurs when you purchase additional shares, purchase new shares, sell only a portion of the original or new shares, and hold on to shares. Additionally, the wash sale rule applies to the aggregate of your accounts, including your IRAs, so you will want to be very careful if you have the same stock in different brokerage accounts. A CPA can help you in these situations to make sure the wash sale rule is applied correctly.

If you don’t want to wait 31 days to buy the same stock or security, you may consider replacing the investment you sold at a loss with an ETF tied to the company’s industry or sector. In this way, the ETF effectively serves as a temporary proxy for individual stock holdings and still enables you to recognize the investment loss on your original position.

Cost basis calculation

Cost basis is the original value or purchase price of an asset or investment for tax purposes. Determine what you originally paid for your stocks in order to calculate your capital losses and gains. To make this calculation, find the date when you first bought the securities and the price you paid.

This might be challenging if you bought securities over time using dollar-cost averaging. You can contact the brokerage firm you bought securities from, which should be able to provide this information to you.

The bottom line

Tax optimization is one part of your overall financial plan. You can take a few actions now to get yourself on the right track.

  1. Sign up for our free financial dashboard. Millions of people use these free and secure online financial tools. You can use them to see all your accounts in one place, analyze your investments and uncover fees, and plan for your long-term financial goals.
  2. Consider talking to a financial professional for more detailed guidance on your tax-optimization strategies.


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