Tax loss harvesting allows investors to offset capital gains by intentionally selling other investments at a loss, but there are limits to how much of these losses can be applied. The tax loss harvesting limit depends on whether the loss is used to offset capital gains or ordinary income. This strategy can be particularly useful in managing taxable investment accounts, and a financial advisor can provide insights into how this could benefit your investment portfolio.
What Is Tax Loss Harvesting?
Tax loss harvesting is an investment strategy used to reduce the amount of taxes owed on capital gains by selling securities at a loss to offset those gains. This strategy is typically applied in taxable accounts, as tax-advantaged accounts like IRAs and 401(k)s don’t benefit from this approach.
When an investment decreases in value, an investor may choose to sell it, thereby “harvesting” the loss and effectively lowering their total taxable investment income. Tax loss harvesting can help investors manage the timing of gains and losses in their portfolio. By strategically selling underperforming investments, investors may optimize their tax situation while still maintaining their broader financial goals.
How Tax Loss Harvesting Limit Works
Tax loss harvesting lets investors use capital losses to offset capital gains and reduce taxes. For example, if an investor has $10,000 in gains but sells another investment at a $15,000 loss, the $10,000 gain is fully offset, with $5,000 in extra losses. Up to $3,000 of these losses can reduce ordinary income ($1,500 for married individuals filing separately), and the remaining $2,000 can be carried forward to offset future income until fully used.
For those who regularly realize large losses, the carryforward provision offers some flexibility, allowing them to spread the benefit of their losses across multiple years. This can be useful for long-term tax management, even if the immediate impact is limited by the annual cap.
Tax Loss Harvesting Rules
Several rules govern tax loss harvesting, helping to ensure the strategy is used correctly within the tax code.
One key rule is that harvested losses must come from investments sold at a loss – gains cannot be offset unless a sale has been executed. These losses are first applied against capital gains from the same type of income – long-term losses offset long-term gains, and short-term losses offset short-term gains. Any remaining losses can then be applied to the opposite type of gain.
The wash sale rule is also important in tax loss harvesting. Under this rule, an investor cannot repurchase the same or “substantially identical” security within 30 days before or after the sale. This rule prevents investors from selling a losing investment simply to claim the loss while immediately re-entering the same position. If a wash sale occurs, the loss is disallowed and added to the cost basis of the repurchased asset.
When to Harvest Your Losses
Investors may choose to harvest tax losses in different situations to improve their current tax outcome. Here are five common examples to keep in mind:
- Reducing ordinary income: Investors may choose to harvest losses to reduce ordinary income. This strategy can be helpful for investors looking to lower their overall tax burden in a given year.
- Rebalancing a portfolio: Tax loss harvesting can be useful when rebalancing an investment portfolio. If an investor wants to adjust their asset allocation but some investments have lost value, selling those positions to harvest losses can allow them to rebalance without triggering additional tax burdens.
- Managing future taxes: Investors may also harvest losses in years when they have no gains to offset, banking those losses for future use. These excess losses can be carried forward indefinitely, offering a flexible tool for managing future tax liabilities.
- Exiting underperforming positions: If an investor wants to sell a security that has underperformed, tax loss harvesting offers a way to soften the blow of a poor investment decision.
- Tax planning in high-income years: In years when an investor expects a higher-than-usual income, harvesting losses can provide a way to offset that income, potentially lowering their tax bracket or minimizing the impact of higher taxes.
Bottom Line
The tax loss harvesting limit allows investors to offset up to $3,000 of ordinary income each year, with any excess losses carried forward indefinitely. While the $3,000 limit may seem modest, investors can use it strategically over time to reduce their taxable income and spread the benefits of larger losses across multiple years. By applying excess losses in future tax years, investors have the flexibility to manage tax liabilities when gains or higher income occur.
Investment Planning Tips
- A financial advisor can help you analyze investments and manage your portfolio to lower your tax liability. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much you could pay in taxes for the sale on an investment, SmartAsset’s capital gains calculator could help you get an estimate.
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