Savvy investors are always looking for ways to reduce their tax burdens. Although no one can completely avoid taxes, harnessing the power of tax-loss harvesting is one smart way to save.
No one buys an investment with the expectation that it will lose money. But tax-loss harvesting provides a unique opportunity to benefit from downturns when they occur.
Through tax-loss harvesting, you can use losing investments to offset your realized capital gains and/or some of your ordinary taxable income. Keep reading to learn all about how it works!
What Is Tax-loss Harvesting?
Before we get into the how-tos of tax-loss harvesting, it's important to first understand what it is. Essentially, tax-loss harvesting is a strategy that involves selling investments that are down in order lower your tax liability.
After this transaction, the investment sold at a loss will offset realized capital gains. And, with that, you're able to reduce your taxable income for the year. Sold investments are then replaced with similar investments in hopes of earning a profit on future growth.
Tax-loss harvesting can be a useful strategy for investors that want to minimize the tax they owe on their investments. Let’s take a closer look at the ins and outs of tax-loss harvesting.
How To Harvest Tax Losses
Many robo-advisors include automatic tax-loss harvesting as part of their advisory services. But if you're interested in implementing tax-loss harvesting on your own, the good news is that it's a relatively simple process.
Step 1: Monitor Your Investment For Value Loss
Take the time to monitor your portfolio for investments that are losing value. When you notice a substantial drop in your investment’s value, it may be time to consider implementing a tax-loss harvesting strategy.
Step 2: Sell Investment At A Loss
When you find an investment that has lost value, you can sell it. At that point, you will realize a capital loss. Without the action of selling the investment, the capital loss remains unrealized and you miss out on the chance to harvest the tax losses.
For example, let’s say you invest $10,000 into a mutual fund. Six months later, the investment’s value has dropped to $8,000. If you miss the chance to sell your investment and it rebounds to $11,000, you won’t be able to use the temporary loss in value to reduce your tax liability.
Step 3: Repurchase A Similar Investment
Once you sell your original investment, it's time to reinvest your funds. When you select a new investment, you'll need to make sure that you are purchasing something similar but not identical.
The IRS will not allow you to pursue tax-loss harvesting if you purchase identical investments, otherwise known as a wash sale. A similar investment cannot be "substantially identical" to the original investment.
However, it's possible to purchase different ETFs that target similar industries. Buying a similar investment will allow you to stick with your overall investment goals while taking advantage of short-term losses to minimize your tax drag.
Step 4: Claim The Loss
Once you’ve completed the mechanics of a tax-loss harvesting transaction, the next step is to claim the loss on your tax return. This final step will allow you to realize the tax loss in a meaningful way.
Depending on your capital gains tax bracket, you could save thousands with the help of this tax minimization strategy.
Limitations Of Tax-Loss Harvesting
Although tax-loss harvesting can be an exciting way to potentially save thousands, there are some limitations to be aware of. These limitations have been set by the IRS as a way to prevent abuse.
Wash Sale Rules
The wash sale rule prevents investors from attempting to harvest tax losses with identical investments. Under this rule, you cannot claim a capital loss on the sale of a security against a capital gain of the exact same security.
With that, you cannot buy and sell identical securities within 30 days before or after the sale to claim a capital loss. If you move forward with the buying and selling of identical securities within 30 days, the IRS will not allow you to claim a tax write-off.
Importantly, you can replace investments with similar mutual funds of ETFs. With similar mutual funds, your investment portfolio can be relatively similar without violating the wash sale rule.
Only Benefits Taxable Accounts
Tax-loss harvesting is only possible in taxable investment accounts. Other investment accounts that are tax-deferred, like an IRA or 401(k), won't benefit from tax-loss harvesting as are they aren't subject to capital gains taxes.
Limits On Offsetting Ordinary Income
There is no limit to the amount of investment gains that can be offset with tax-loss harvesting. However, there are limits to the amount of taxes on ordinary income that can be offset.
As a married couple filing jointly or a single filer, you can realize up to $3,000 of capital losses to reduce your ordinary taxable income in a given year. If you're a married couple filing separately, then you'll only be allowed to claim up to $1,500 of capital losses in a given year.
Due to these limitations, there may be certain years that you have more capital gain losses than you can claim on your tax return. The good news is that you can carry these losses over to future tax years.
If you're aiming completing a tax-loss transaction each time one of your investments lose value, the strategy could become burdensome in multiple ways.
First, you may incur transaction costs if you don't have a commission-free stock broker. And, second, frequent tax-loss harvesting could lead to higher tax prep costs when it comes time to file your return.
Before implementing tax-loss harvesting in your own portfolio, weigh the costs of completing the transaction and filing your taxes. You don’t want to go through the effort of harvesting a tax loss if the costs would outweigh the savings.
As you consider tax-loss harvesting, don’t prioritize this strategy over the value of a well-balanced portfolio. Although you can save on your tax bill through this strategy, it shouldn't take precedence over building a portfolio that aligns with your investment goals.
If you're starting out on your investment journey, take advantage of our free resources to help you build a portfolio that works for you. And if you're looking for a "set it and forget it" tax-loss harvesting option, you may want to open an account with one of the top robo-advisors that can execute all the transactions automatically on your behalf.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.