What is tax loss harvesting?

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The universal investment strategy is "buy low and sell high." When you start your investment, you don't anticipate losses. However, the market is unpredictable, and factors such as rising interest rates and high inflation will likely leave your portfolio with some red.

Luckily, there’s a silver lining – you can use the losses to your advantage to lower your tax liability from realized capital gains and taxable income. This is known as tax loss harvesting.

If you have any underachievers in your portfolio, this might be your ticket to a lower tax bill.


Key insights

Tax loss harvesting involves selling investments at a loss to lower tax liability from realized capital gains.

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If your capital losses exceed your capital gains, you can deduct up to $3,000 (and $1,500 if you're married and filing separately) from your taxable income.

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If you don't have capital gains to offset the 'harvest,' the loss is carried forward to offset future gains.

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How does tax loss harvesting work?

Tax loss harvesting involves selling an investment at a loss and using that loss to offset gains from other assets. Investors evaluate the performance of their investments annually and determine how they might impact their taxes. If an investment shows a loss in value, they "harvest" it and sell it at a loss to lower or eliminate the tax they have to pay on the capital gains they earn from other investments.

Let's use an example for a better understanding:

Suppose you buy two stocks (A & B) worth $15,000 each. After a year, you sell both investments and earn a profit of $5,000 from A and a loss of $10,000 from B. You've realized a long-term capital loss of $10,000. After you use $5,000 to offset the entire tax you owe from your capital gain of $5,000, you still have capital losses worth $5,000. You can reduce your ordinary taxable income by $3,000 and use the $2,000 to offset tax liability in the future.

» MORE: Capital gains vs. investment income: how they differ

Tax loss harvesting strategies

While tax loss harvesting is straightforward, using the following strategies can help reduce tax liability and lower your risk without damaging your portfolio.

Wait until you're in a higher tax bracket.

The main incentive of tax-loss harvesting is lowering the tax you owe to the Internal Revenue Service (IRS). Therefore, if you're in a low tax bracket and already have a low tax bill, there's no need to sell your securities at a loss. If you anticipate a tax raise or expect to be in a higher tax bracket, wait and sell your securities then.

“Tax loss harvesting is most beneficial in years when an investor has realized capital gains that can be offset by losses. It's particularly relevant for investors in higher tax brackets or those with significant investment income,” says Marcel Miu, founder and wealth planner at Simplify Wealth Planning.

Be aware of the deadline

While you can wait to open or fund an IRA account at the last minute, the IRS has no grace period for tax-loss harvesting. You must complete the harvesting by Dec.31.

Wise investors monitor and harvest their losses as the market changes to avoid the rush. You can also use an automatic tax loss harvesting tool.

Only sell if it's necessary

Don't be short-sighted and sell your investments at a loss for tax relief. The main objective of investing in stocks is to allow the magic of time and compounding to multiply your money.

Therefore, unless there's something incredibly wrong with your investment, it's best to hold on to it.

Spend wisely

A lower tax bill is not the only benefit you get from tax-loss harvesting; you also get some of your money back, and what you do with that money matters. Rebalance your portfolio by introducing a new investment or adding to a stock that has potential.

“Tax loss harvesting is a nuanced strategy that can offer significant tax benefits under the right circumstances. However, it's not a one-size-fits-all solution and should be considered as part of a broader financial plan. Consulting with a licensed financial advisor who understands your financial situation and goals is crucial before implementing this strategy,” says Marcel.

Allowances and restrictions on tax loss harvesting 

Tax loss harvesting sounds easy, but it draws from several tax codes. If you're managing your tax-loss harvesting, here are some rules you need to heed.

Deduction limit

If your capital losses exceed your gains, the IRS allows you to deduct up to $3,000 ($1,500 if you're married and filing separately) from your ordinary taxable income. If you still have a balance after the $3,000 write-off, it's carried forward and deducted from future tax liability or capital losses.

Expiration date

Capital losses don't have an expiration date. Even if you don't have any tax liability or capital gains to offset in the current year, you can use them to offset future gains. The IRS allows you to offset future capital gains until capital losses are used up.

Account types

The tax harvesting strategy is only effective in offsetting taxable investment gains. Since the IRS doesn't tax the capital gains of deferred accounts such as IRAs, 401(k) and 403(b) plans, there’s no need for tax relief. If you don't withdraw the funds in these accounts before time (591/2 years and above), they can generate money without the IRS asking for a piece of your pie.

Tax harvesting applies to taxable accounts, such as brokerage accounts, where you must report capital gains or losses while filing your annual taxes.

Wash-sale rule

A wash-sale occurs when an investor sells a stock at a loss and, within 30 days before or after the sale, buys an identical security, a "substantially similar" asset again. If the IRS considers a transaction a wash-sale, you can’t use it to offset the capital gains from other investments.

The wash sale doesn't only count for you; if your spouse buys a similar security, it's still considered a wash sale. If you want to buy the same asset to align your investment strategy, it's advisable to wait a couple of extra days just to be safe.

» MORE: Tax relief companies

Pros and cons of tax loss harvesting

Tax loss harvesting can be a good option since it allows you to reduce the tax you owe on the capital gains of other securities. However, tax harvesting isn’t always beneficial for everyone. Tax-loss harvesting benefits individuals in a high-income tax bracket — the higher the income tax bracket, the higher the tax savings.

Here are the pros and cons to consider when harvesting.

Pros

  • Save on taxes
  • Grow your investment portfolio
  • Reduce cost and risk

Cons

  • Missing out in the long term
  • The wash-sale rule
  • Not financially fruitful if you're in a low tax bracket

Owe the IRS thousands? See if you qualify for relief.

    FAQ

    Can I use cryptocurrency for tax loss harvesting purposes?

    Yes, cryptocurrency is a perfect investment for a tax-loss harvesting strategy because it's exempted from the wash-sale strategy. You can sell and repurchase your coins immediately without repercussions.

    What are the best investments for tax loss harvesting?

    An investment with a negative return is the best tax loss harvesting candidate. It should also be an investment you're willing to miss out on any potential returns within 30 days of selling because you can't buy it before that timeframe.

    How much tax loss harvesting can I do in a year?

    There’s no limit to tax loss harvesting in a year. You can harvest as much as you can because tax losses can be carried forward to offset future capital gains.

    Bottom line

    Tax-loss harvesting is selling investments at a loss to reduce the tax you owe on other capital gains. You can offset the taxes of your capital gains and use the capital losses to write off up to $3,000 of your ordinary income to reduce your taxable income. If you still have leftover capital losses, you can forward them to offset future gains until the net losses are used up.

    However, while tax-loss harvesting sounds like a great strategy, be mindful of selling securities with the potential for a few bucks while taxing returns.

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