All About Tax-Loss Harvesting for Investors

Tax-loss harvesting is a strategy that allows investors to offset capital gains by selling investments at a loss, potentially reducing their tax liability. This approach is commonly used in taxable accounts to balance gains and losses within the same year or to carry forward losses to future years. While it can be a useful tool for managing tax exposure, investors should be aware of the wash-sale rule, which prevents the immediate repurchase of a “substantially identical” security.

A financial advisor can address your tax-loss harvesting questions and potentially provide financial advice to maximize your tax savings.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is the practice of selling investments at a loss to offset taxable capital gains. This strategy is commonly used in brokerage accounts, where capital gains taxes apply to profits from the sale of stocks, bonds, mutual funds and ETFs. By realizing a loss, an investor can reduce their overall tax liability, potentially lowering the amount owed to the IRS.

Losses can be used to offset gains on a dollar-for-dollar basis, and if total losses exceed gains, up to $3,000 can be deducted against ordinary income each year, with any remaining losses carried forward to future tax years. However, tax-loss harvesting does not apply to tax-advantaged accounts like 401(k)s or IRAs, where gains and losses do not directly impact annual tax filings.

The Wash Sale Rule

A key factor to keep in mind is the wash-sale rule, which blocks investors from buying the same or a nearly substantially identical security within 30 days before or after selling it at a loss. This regulation is designed to stop investors from immediately repurchasing an asset solely to secure a tax deduction while keeping their portfolio unchanged. To comply with the rule while preserving market exposure, investors can reinvest in a different but comparable security.

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 the more favorable long-term capital gains rate, while investments held for less than a year and then sold 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 24% 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

Without harvesting your losses, you would have to pay $26,250 in capital gains tax on the two gains that you realized. The long-term capital gains tax rate of 15% would apply to the $75,000 gain, while your 24% marginal income tax rate would be applied to the $60,000 short-term gain. 

($75,000 x 15%) + ($60,000 x 24%) = $25,650

But by implementing tax-loss harvesting, you would sell Investments A and C at a loss to reduce the size of your corresponding taxable gains from selling Investments B and D.

To do this, you would subtract your long-term capital loss (Investment A) from your long-term capital gain (Investment B) and multiply it by your long-term capital gains tax rate (15%). Then, you would subtract your short-term loss (Investment C) from your short-term gain (Investment D) and multiply by 24%.

• $75,000 – $50,000 = $25,000 x 15% = $3,750
• $60,000 – $25,000 = $35,000 x 24% = $8,400

By adding those totals together, you would then owe just $12,150 in capital gains tax.

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.

• Wash Sale Rule: As mentioned above, the IRS prevents investors from deducting a loss on a security if they buy the same or a nearly identical one within 30 days before or after selling it. To maintain the tax benefit, investors must either wait out this period or choose a different investment that offers similar exposure without breaching the rule.
• Tax-advantaged accounts: Tax-loss harvesting is only relevant for taxable brokerage accounts. Losses realized in tax-deferred or tax-free accounts, such as 401(k)s or Roth IRAs, do not provide tax benefits because gains in these accounts are not subject to immediate taxation.
• Long-term vs. short-term gains: Losses must first offset gains of the same type. Short-term losses apply to short-term gains, which are taxed at higher ordinary income rates, while long-term losses reduce long-term gains, which have lower tax rates. Any excess losses can be used against ordinary income or carried forward to future years.
• Market and portfolio impact: Selling investments at a loss alters portfolio composition. Investors should evaluate whether replacing the sold asset with a different but similar security aligns with their long-term investment strategy.

Working with a financial advisor or tax professional is crucial to your success with tax-loss harvesting if you aren’t familiar with this strategy.

When to Implement Tax-Loss Harvesting

Tax-loss harvesting is a great tool for anyone with capital gains and losses. However, 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.

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. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with 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.
• Consider using SmartAsset’s capital gains calculator to see what you could be paying on your investment gains.

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