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Ask Our Taxes Expert

Have a question? Ask our Taxes expert.

Have questions? Email Send your question to jmansfield@smartasset.com

All About Tax-Loss Harvesting

Depending on how proactive you are about investing, you may or may not have heard the term tax-loss harvesting before. If you’ve only invested in your future by contributing to a retirement account, tax-loss harvesting won’t help you. But if you have some taxable investment accounts, tax-loss harvesting may lower your tax liability and potentially save you money.

Check out our federal income tax calculator.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a method of using your investment losses to lower your taxes on capital gains. Basically, it shows the IRS that while you made money from some investments, you lost money from others. Therefore, you don’t owe as much in taxes.

The process of tax-loss investing involves selling assets at a loss and buying similar investments. It allows you to take advantage of your losses for tax purposes and maintain your desired asset allocation.

Wondering why you have to sell an investment in order to realize a loss? Consider what it’s like to buy a new car. Its value depreciates as soon as you leave the lot, but you won’t realize the loss or see it impact your wallet until you try to sell the car. Similarly, you may know that your assets are underperforming, but you can’t claim your losses until you your investments.

How Tax-Loss Harvesting Works

All About Tax-Loss Harvesting

Tax-loss harvesting can significantly lower the size of your income tax bill. Once you’ve sold some of your securities and realized the losses on those investments, you can subtract those losses from your capital gains. If you have any leftover losses, you can use them to offset taxes on wages and other income by up to $3,000 and carry additional losses forward to use on future tax returns.

Keep in mind that investments held for more than 365 days are taxed at a long-term capital gains rate. But investments held for less than a year are taxed at your normal income tax rate.

Let’s look at an example of how tax-loss harvesting works. Let’s say you have the following assets and you fall into the 25% tax bracket (meaning your long-term capital gains are taxed at a rate of 15%).

 1. Investment A: $50,000 unrealized loss, held for 400 days

2. Investment B: $75,000 realized gain, held for 375 days

3. Investment C: $25,000 unrealized loss, held for 200 days

4. Investment D: $60,000 realized gain, held for 300 days

By implementing tax-loss harvesting, you’d owe $12,500 in capital gains tax.

(($75,000 – $50,000) x 15%) + (($60,000 – $25,000) x 25%) = $12,500

Without tax-loss harvesting, you would have to pay $26,250 in capital gains tax. 

($75,000 x 15%) + ($60,000 x 25%) = $26,250

In our example, tax-loss harvesting results in a tax bill of almost half of what you would otherwise pay in taxes. Using a capital gains tax calculator can help you calculate your own tax liability and determine how much money you’d save through tax-loss harvesting.

Who Should Take Advantage of Tax-Loss Harvesting?

Tax-loss harvesting is a great tool for anyone with capital gains and losses. But long-term investors stand to save the most money by using this strategy.

The longer you hold onto your investments, the more your savings will compound. Additionally, if you hold onto your investments for more than a year, they are automatically taxed at a lower rate. Minimizing your tax liability can boost your net worth over time.

When to Implement Tax-Loss Harvesting

All About Tax-Loss Harvesting

Investors often harvest their investment losses near the end of the year. But you could sell off your investments at any time.

Waiting until the end of the year to consider tax-loss harvesting could be helpful if you want to use your losses to offset the gains that have accumulated throughout the year. But selling your losses earlier in the year could give you the chance to repurchase some of your investments later on (possibly for a cheaper price) when everyone else is selling their securities.

Don’t Forget the Wash Sale Rule 

Tax-loss harvesting is a strategy that you can use to lessen your tax bite. By using your losses to lower your taxes on capitals gains and income, you can save money. Just remember to take the wash sale rule into account.

The wash sale rule prohibits you from deducting losses when you sell and then buy substantially identical securities within 30 days before and after the sale. One way to avoid that rule is to invest in exchange-traded funds (ETF). As long as you’re not switching from one ETF to another that tracks an identical index, the wash sale rule won’t apply.

Photo credit: ©iStock.com/AndreyPopov, ©iStock.com/PhotoBylove, ©iStock.com/Rawpixel

Elizabeth Stapleton Elizabeth Stapleton is an attorney and freelance writer focusing on personal finance and entrepreneurship. Her expertise includes home buying, retirement and taxes. Elizabeth lives in North Carolina.
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