From time to time, even the best investors out there endure some losses; but the savviest among them see the silver lining in the same and enlist the help of dedicated strategies such as tax-loss harvesting, a powerful tool for reducing your tax bill and optimizing your investment portfolio. This article explores this topic in more detail so you can learn all about it. Let’s dive in!

What is tax-loss harvesting?

Tax-loss harvesting is a technique investors use to minimize their tax liability by selling investments that have experienced a loss.

Utilizing this approach can benefit your taxes in two ways; losses are used to offset investment gains and, in some cases, also reduce your personal income tax by allowing you to write off up to $3,000 a year (or $1,500 each for married taxpayer filing separately).

Furthermore, any unused losses are carried over to offset future gains or income when needed in the absence of an expiration date. In other words, tax-loss harvesting allows you to leverage poor-performing investments by lowering your tax bill.

The overall concept is rooted in the tax code's treatment of capital gains and losses, allowing investors to use losses to offset gains. By strategically timing the sale of investments that have declined in value, investors can minimize their tax liability without significantly altering their overall investment strategy.

How does tax-loss harvesting work?

As tax-loss harvesting is all about capital gains and how they’re taxed, let’s start right there.

Say, for example, you sell Investment A for a net profit of $10,000 but owe short-term capital gains tax as you had owned it for less than a year. These tax rates vary based on income but can rise as high as 37% (as of 2024); assuming you’re in the tax bracket that owes 35%, you’d be liable for $3,500 in taxes on your $10,000 profit. NOW let’s implement a tax-loss harvesting strategy to see how this changes your tax liability…

Earlier that same year, you bought Investment B—which performed poorly, so you sell it for a loss of $15,000. In this case, you can use that $15,000 loss to offset your gains from Investment A: thus owing no capital gains tax on that profit.

That’s not all, however. You still have an additional $5,000 loss ($15,000 minus the offsetting $10,000 profit from Investment A) and can use $3,000 of this to offset your personal income AND apply the remaining $2,000 loss to future gains or income during another tax year.

Thanks to the tax-loss harvesting strategy, your overall tax savings (in this example) could ring in as high as $4,550: the $3,500 you owed in taxes for Investment A plus 35% of the $3,000 applied towards your income (or $1,050). This doesn’t even include the $2,000 you can still apply to future gains or income.

Perhaps you’re asking: “What if I don’t have any capital gains taxes to offset? Can I still benefit from tax-loss harvesting?” The short answer is YES. Here’s how…

Let’s say you bought Investment C for $8,000 and sell it for $6,000, resulting in a $2,000 loss. You could then take the proceeds ($6,000) and reinvest them in Investment D in the hopes that this will perform better than the others, using the $2,000 capital loss to offset your taxable income for that year (based on 35%, your income tax benefit would be $700 ($2,000 x 35%))—reinvesting your $700 tax savings as part of a long-term strategy.

While some tax-loss harvesting limitations do exist (which we’ll touch on next), regularly taking advantage of this strategy allows you to maximize your money. For example, those who regularly rebalance their portfolio can use tax-loss harvesting to transform inevitably poor performers into tax savings.

Important tax-harvesting rules to follow

Tax-loss harvesting is often a valuable approach, but as with most tax strategies, it does involve some specific rules and complexities. These include:

Wash-sale rule

One of the biggest issues investors must be mindful of with tax-loss harvesting is the wash-sale rule, which prohibits the repurchase of a "substantially identical" security within 30 days of a sale that resulted in a loss. Violating this rule can nullify the tax benefits of the transaction, but note you can still replace ETFs that track similarly or even the same index without doing so.

Taxable accounts only

As the entire objective of tax-loss harvesting is to offset capital gains taxes, it only applies to taxable accounts and not tax-sheltered accounts such as 529s, IRAs, 401(k)s, and 403(b)s.

Realizing losses before year-end

As with many other tax strategies, you’ll need to complete your tax-loss harvesting efforts before the end of the calendar year (December 31) and consider this approach within the context of your overall tax strategy.

Long-term vs. short-term capital gains

Capital gains tax treatment varies depending on the holding period of the investment as well as your income. Long-term capital gains apply to assets held for longer than a year and are typically taxed at a lower rate (0%, 15%, or 20%, depending on income) than short-term gains: which are taxed at the same rate as ordinary income. Since tax-loss harvesting is all about offsetting capital gains taxes, it’s most beneficial for those in higher tax brackets.

Netting gains and losses

Investors can offset capital gains with capital losses, but it's crucial to calculate the net gain or loss in an accurate manner. This may sound straightforward (and it often is!), but issues can arise if you don’t buy all shares concurrently. For example, Company A stock purchased once a month using a dollar-cost averaging strategy likely reflects fluctuating prices. Calculating your net gain or loss in this case is a bit more complicated, and good records are necessary to ensure you report a proper cost basis to the IRS.

Deductions limitations

Tax-loss harvesting can of course help offset losses—but only so much. The IRS imposes limitations on the amount of capital losses you can deduct in a given tax year, impacting the effectiveness of this strategy.

Tax-loss harvesting limitations

While tax-loss harvesting is often an effective strategy, it’s important to recognize its limitations. These include:

Market-timing risks

Attempting to time the market to realize losses is often challenging and may result in missed opportunities for gains. If an investment is part of your portfolio, it’s ideally because you believe in its long-term growth potential. Remember, however, that the market fluctuates; selling an investment the moment it dips will make it almost impossible to maintain a long-term portfolio that grows over time. Tax-loss harvesting is therefore best used as part of a larger strategy (e.g., rebalancing).

Administrative burden

Implementing tax-loss harvesting requires careful record-keeping and investment monitoring, both time-consuming tasks. Thankfully, working with a financial advisor can help streamline this process.

Tax code changes

While Benjamin Franklin’s words “Nothing is certain but death and taxes” may well be true, this certainly doesn’t mean taxes stay the same over time. The tax code and regulations are constantly evolving, and these updates can impact tax-loss harvesting effectiveness. It’s therefore suggested you work with a tax professional to help limit the risk you’ll leave money on the table and/or make costly errors.

The takeaway

Tax-loss harvesting offers several benefits for investors including reduced tax liability, portfolio optimization, and enhanced returns; making the most of this strategy, however, requires a solid understanding of various tax rules, implications, and limitations. With careful planning and guidance from a financial professional, you can count tax-loss harvesting among the most powerful tools in your financial toolkit.

Still have questions about tax-loss harvesting? Schedule a FREE Discovery call with one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.