No one likes paying taxes. And no one is happy when an investment loses money. As an investor, you probably can’t avoid either one of these scenarios, but you can learn about tax-loss harvesting to help make the most of both.
What is tax-loss harvesting?
Tax-loss harvesting is a way to balance the gains in your portfolio with losses. In simple terms, it’s a way to manage your investment taxes by selling some of your investments at a loss (aka a capital loss) to reduce your capital gains (or the profit you made by selling a security for more than you purchased it for).
Tax-loss harvesting can be used to reduce your tax liability from:
- Short-term capital gains: When you sell a security you’ve held for less than one year. Short term capital gains are taxed at your ordinary income tax rate.
- Long-term capital gains: When you sell a security that you’ve owned for more than a year. The long-term capital gains tax rate is 0%, 15% or 20%, depending on your adjusted gross income and filing status.
By selling some of your losing investments and replacing them with similar — but not identical — ones, you can keep more of your money in the market and simultaneously reduce your tax bill.
How does tax-loss harvesting work?
A tax-loss harvesting strategy is simple in theory. First, it requires you to have money invested in a taxable investment account. (Tax loss harvesting rules don’t apply to a traditional IRA or Roth IRA, since you’re already getting tax benefits with those accounts.)
Now, assume you buy 100 shares of ABC stock and 100 shares of XYZ stock at $10 each. The ABC stock takes off, doubling in value and setting you up to realize a capital gain when you sell those shares. But the XYZ stock experiences a price drop and its value is cut in half. So you sell and experience a capital loss.
Your capital loss offsets your capital gain, reducing what you owe in taxes on the portion of your portfolio that was profitable. You can think of tax-loss harvesting as rebalancing your portfolio to realize tax savings.
Who does tax-loss harvesting?
You can tax-loss harvest yourself in a taxable brokerage account, like our Self-Directed Trading account. All you’d do is review your portfolio at year’s end and pick out the profitable securities. Then, you would identify the ones that have lost value and sell them.
Some robo-advisors also offer tax-loss harvesting and portfolio rebalancing. The benefit of using a robo-advisor to invest is that tax-loss harvesting and rebalancing can be automatic, so there’s no heavy lifting for you — a plus if you lean more towards a hands-off investing strategy.
Tax-loss Harvesting Limits
The beauty of tax-loss harvesting is that you can use capital losses to offset all your capital gains. Even better, if your capital losses are more than your gains, you get a bonus tax benefit. In this scenario, you can use any remaining losses to offset up to $3,000 of ordinary taxable income for the year. This is the maximum capital loss deduction you can claim, depending on filing status, as of 2021.
Should you have additional losses after meeting the threshold, you can carry them forward to offset future income. So in a sense, tax-loss harvesting can be a gift that keeps on giving year after year.
Is tax-loss harvesting worth it?
The answer can depend largely on your tax bracket and how long you hold investments before selling them. The higher your tax bracket, the more you could potentially save through tax-loss harvesting. If you’re in a lower tax bracket, you could still tax-loss harvest but it might not yield as much tax savings.
It’s also important to consider how a capital gain and a capital loss can be used together. A long-term capital loss is applied to long-term capital gains first, then short-term capital gains. Likewise, short-term capital losses are applied to short-term capital gains first.
And importantly, you need to watch out for the wash sale rule. This means you can’t sell a security to realize a capital loss, then replace it within 30 days with the same (or a significantly similar) security. Violate the wash sale rule and you forfeit any tax benefits you might have realized from harvesting losses.
Benefit from tax-loss harvesting as you grow wealth.
By offsetting the amount of taxes you owe from capital gains, tax-loss harvesting can be a way to turn lemons into lemonade. If a security in your portfolio experiences a loss of value, tax-loss harvesting can be a smart move that nets you a lower tax bill.
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