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A woman calculates her tax bill for selling an investment. Tax-loss harvesting is a tactic that involves selling investments at a loss to offset capital gains.

Make no bones about it: 2022 has not been kind to investors. Persistent inflation, rising interest rates and the Russia-Ukraine War have all driven major stock market indexes down through the first four-plus months of the year.

As of May 25, the S&P 500 was down 17%, while the Dow Jones Industrial Average had dropped more than 12% since the start of the year. The Nasdaq Composite has fared even worse, falling nearly 28% in 2022. Those licking their wounds as they assess the red in their portfolios may be on the hunt for practical ways to staunch the hemorrhaging.

And there’s some good news: These market losses present an opportunity of sorts for investors. No, you don’t have to be an optimist – just a pragmatist willing to handle your portfolio’s downside strategically. How? Those who make a profit from selling investments can lower their tax bills associated with those gains by selling investments that they’ve lost money on. This is known as tax-loss harvesting, and it can be an especially effective strategy for lowering your tax liability and preserving a larger percentage of your investment gains.

Below, we’ll show you the impact that tax-loss harvesting can have on an investor’s bottom line. For help with tax-loss harvesting and other portfolios moves, consider working with a financial advisor.

Scenario 1: Investment Losses Aren’t Harvested

Imagine a scenario in which an investor, Kevin, sells enough stock to produce $60,000 worth of capital gains in a given year. However, not all of Kevin’s investments have been winners. He also has a stock in his portfolio that has gone down in value since he purchased it several years earlier. If he were to sell that stock today, he would take a $30,000 loss. Instead of offloading his losing position, Kevin hangs on to the stock in hopes that it will rebound.

Kevin has a high income and is subject to a 20% long-term capital gains tax rate. As a result, he has a tax liability of $12,000 associated with his $60,000 in capital gains ($60,000 x 20%). After paying taxes on the gains, he’s left with a $18,000 net profit (realized and unrealized) across his two investments.

Scenario 2: Investment Losses Offset Gains

Now consider a scenario in which a hypothetical investor named Kim uses investment losses to offset some of her capital gains. Kim’s investments don’t perform quite as well as Kevin’s, but she’s still able to generate $55,000 in long-term capital gains over the course of the year. And like Kevin, Kim also has $30,000 of investment losses in her portfolio.

However, Kim opts to offload these losing investments. Selling at a loss stings, but doing so lowers her realized capital gains by $30,000. As a result, she only pays taxes on her net capital gain, $25,000. Harvesting her losses lowers her tax bill to just $5,000, meaning she’s left with $20,000 after paying the IRS.

Despite the fact that her investments underperformed compared to Kevin’s, Kim ends up with more money because she harnessed the power of tax-loss harvesting.

Bottom Line

As you can see, harvesting investment losses for tax purposes can be a savvy portfolio move. However, it relies on accepting the reality that a previous investment did not pan out, and as a result, cutting your losses. While Kevin ends up paying more in taxes and is left with less profit than Kim, choosing not to sell the losing investment means he can still benefit from a potential rebound in the future.

Tips for Managing Your Portfolio

  • Turn to a pro. If you’re unsure how to invest your money, a financial advisor can help. Advisors can select investments on your behalf and occasionally rebalance your holdings to keep your portfolio in life with your financial goals. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Don’t try to time the market. While it may be tempting to sell assets right before a market dip, predicting the right time to do so is exceedingly difficult. Bob French, a chartered financial analyst (CFA) and director of investment analysis for Retirement Researcher, found that market timing strategies are hypersensitive and can easily underperform compared to buy-and-hold tactics. Mistiming your exit or reentry into the market by even one month can drastically alter an investor’s long-term outcomes.
  • Keep track of your investment timeline. Keeping track of how long you’ve owned an asset is vital, especially when it comes time to sell it. Gains realized from selling an asset that you’ve held for less than a year are taxed as ordinary income. However, investment gains derived from an asset that you’ve had for over a year receive a more favorable tax treatment and are taxed as long-term capital gains. Use our capital gains tax calculator to estimate your tax liability.

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Photo credit: ©iStock.com/tommaso79

Patrick Villanova, CEPF® Patrick Villanova is a writer for SmartAsset, covering a variety of personal finance topics, including retirement and investing. Before joining SmartAsset, Patrick worked as an editor at The Jersey Journal. His work has also appeared on NJ.com and in The Star-Ledger. Patrick is a graduate of the University of New Hampshire, where he studied English and developed his love of writing. In his free time, he enjoys hiking, trying out new recipes in the kitchen and watching his beloved New York sports teams. A New Jersey native, he currently lives in Jersey City.
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