Tax-loss harvesting is a way to use investment losses to lower your taxes on any capital gains you have in a year. If you’ve only invested in your future by contributing to a retirement account, tax-loss harvesting won’t likely help you. However, if you have some taxable investment accounts, tax-loss harvesting may lower your tax liability and potentially save you money. A financial advisor can help you with any tax-loss harvesting questions you have and help you maximize your tax savings through proper planning.
Tax-Loss Harvesting Defined
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 have your investments.
How Tax-Loss Harvesting Works
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%).
- Investment A: $50,000 unrealized loss, held for 400 days
- Investment B: $75,000 realized gain, held for 375 days
- Investment C: $25,000 unrealized loss, held for 200 days
- 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.
Considerations for Tax-Loss Harvesting
While tax-loss harvesting might be a great opportunity for you to lower your tax bill in the short term, it might not be the best fit for you. Here are a few important details to keep in mind as you consider tax-loss harvesting for your own planning.
- The Process Lowers the Cost Basis: While tax-loss harvesting can lower your tax bill this year, it also automatically lowers the cost basis of the investment you target. This means that you could be paying a higher tax bill in the future as a lower cost basis typically means higher tax bills down the road. This might be important if you anticipate more capital gains to come in the next few years.
- Tax-Loss Harvesting Postpones Tax Obligation: This strategy only works for investment accounts that are taxable and it doesn’t eliminate that obligation. The tax on the investment is postponed, similar to a traditional IRA account. It is a strategy for those looking to save on their current tax obligation in order to reinvest for portfolio growth.
When to Implement 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.
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 capital 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 (ETFs). As long as you’re not switching from one ETF to another that tracks an identical index, the wash sale rule won’t apply.
The Bottom Line
Tax-loss harvesting is a method to use investment losses to lower the capital gains taxes you might have to pay. Anyone who has gains and losses can use this method, but it is especially useful for long-term investors. This is part of the long-term investment tax planning that you may want to consider doing if you have a decent account size in your portfolio.
Tips for Managing Your Money
- A financial advisor can help investors understand what they should be investing in for them to reach their long-term goals and they can help make tax strategies to potentially lower their bills. If you don’t have a financial advisor, finding one 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 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.
- Consider using SmartAsset’s capital gains calculator to see what you could be paying on your investment gains.
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