Tax loss harvesting is a method of selling investments for a loss, in order to offset gains from another sold investment, to reduce taxes owed.
When you sell an investment which has appreciated in value from your date of purchase, they become realized gains.
Those realized gains will typically result in a tax burden which can then be reduced by realizing, or selling investments that have reduced in value from the time of your purchase, for a loss.
Tax loss harvesting can be an effective strategy to reduce or eliminate taxes when you sell an investment with locked in capital gains.
Tax loss harvesting can have multiple benefits.
In this guide, we will seek to explain what tax loss harvesting is, how to do it, and how to determine if it is an appropriate strategy for you.
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Ideally with investments, most people hope that their assets will appreciate in value, so that they can buy low and sell high.
But everyone who has invested knows that this isn't how things go 100% of the time. Sometimes we don't have to take the loss or gain, and we can leave them unrealized.
For example:
You buy a stock for $10 and then the price/ value of that stock drops to $5. You have an unrealized loss of $5.
Another case is you buy a stock for $10 and then the price/ value of that stock raises to $15. You have an unrealized gain of $5.
Actually, selling the stock would make that loss or gain realized, and you would then likely owe taxes on that capital gain, should you have gains in excess of losses.
Selling securities for a loss to offset another investment's sale for a gain can decrease the amount of net capital gain (the amount of long term gain minus long and short term loss) or loss (losses higher than gains) that you had for a given year. This is called tax loss harvesting.
The goal is to reduce taxes owed on winning investments by selling investments that will realize losses.
Remember that you have until the end of any tax year to use these benefits for the following term.
There are things you need to consider and keep an eye out for when trying to accomplish this.
Not being aware of the rules may end up leaving you confused with very little benefit.
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Tax loss harvesting can only be done in TAXABLE BROKERAGE ACCOUNTS.
It is not possible to tax loss harvest in a retirement account, such as an IRA, 401K or ROTH IRA.
Gains within retirement accounts are not taxable as long as the proceeds stay within the account
There are additional complications but this can be summarized as:
Investments in retirement accounts do not have a normal tax basis and follow unique tax rules that disallow tax loss harvesting within these types of accounts.
There are a few things you have to consider when trying to offset capital gains:
The Internal Revenue Service requires that short term losses be first applied to short term gains and long term losses be first applied to long term gains. When trying to harvest losses, it is easy to get stuck here and make a mistake if you aren't aware of this rule. This is something to consult with a financial advisor, preferably one that has your best interest in mind.
Short term means that the date you sold an investment is within 364 days of the purchase date. Long term is selling your investment a full year or longer after the date you bought it.
Short term gains and losses are taxed at INCOME TAX RATES (higher cost and less favorable), yet long term gains and losses are taxed at CAPITAL GAINS TAX RATES (lower cost and more favorable).
Short term capital loss is mainly used to offset ordinary earned income. Short term gains are taxed at your marginal tax bracket, as regular income is, and can incur much higher tax burdens depending on your total income for the year.
You may have heard of the $3,000 limit - this refers to the fact that you can only use $3,000 of net capital losses to offset ordinary income tax (or short term capital gains tax).
Any net capital losses above the $3,000 threshold will have to be used in the following year(s) until that balance is depleted. This is called a “capital loss carryforward”.
Whenever possible we don't want to waste short term losses against long term gain, because this wastes the potential benefit of cutting down the vastly higher short term capital gains tax.
Ideally, we want to sell investments that have unrealized long term capital gains, because of the preferential tax bracket. Long term gains will cost you 0 - 20% called "capital gains taxes". This is lower than ordinary income tax rates, from 10 - 37%, making long term gains a more desirable source for portfolio distributions if you can help it.
Always remember (long term gains - long term losses) and (short term gains - short term losses) first, unless the balance from one type of loss exceeds the balance from its corresponding gain.
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Another rule to consider when attempting to tax loss harvest is the Wash Sale Rule.
This rule prohibits using losses on the same or substantially identical assets if you purchase them within 30 days before or after a transaction (in this case, selling for a loss). This is implemented into the tax code because we could otherwise easily cycle between selling an investment for a loss and buying it right back with a higher cost basis for future repetitions.
This also applies to sales made within a non retirement account, and an immediate rebuy within a retirement account. Beware that attempting this workaround will lose any potential benefits from the initial loss, and the future cost will be purely what you bought the security for.
There a few ways you can try to compromise here but this is still important to remember:
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The wash sale rule can still apply here but you can consider rotating between specific industries and sectors of the market while your cooling off (60 day wash sale) period is still active. A mutual fund or ETF can give you some variety that would previously be inaccessible with an index fund.
For example, you can't sell an index fund tracking the S&P 500, then purchase another S&P 500 fund. However, you can rotate between say healthcare and consumer staples, or any other sectors that may hold your attention, match your desired asset allocation, or are recommended by your financial advisor.
Click here to watch a free webinar that will guide you through the 8 financial planning decisions that could help you extend the lifespan of your retirement assets and increase your retirement income by as much as 38%.
Just because you CAN tax loss harvest and minimize a possible tax burden doesn’t mean you SHOULD tax loss harvest…
Sometimes it can make sense to hold onto an investment that has an unrealized loss.
There is always potential for an investment with an unrealized loss to rebound.
Knowing when to sell an investment to harvest the loss is a skill that comes with time and experience.
We recommend consulting with a fee only fiduciary financial advisor before getting too trigger happy and selling all the unrealized loss positions in your portfolio.
Another reason to carefully consider which securities to sell is if you're using an investment income portfolio. You may be able to tolerate unrealized losses in an investment if the income stream is still matched up with your personal goals or financial needs.
Investing is like gardening. You have to prune the weeds and harvest the fruits of your labor.
Tax loss harvesting is one way to unlock investment gains that you may feel are “inaccessible” because of the tax you might incur should you sell some of that winning position.
But harvesting your gains is a critical part of a long-term investment strategy.
When you do harvest your gains, don't forget to reinvest them! Many people forget to put their harvested gains back into the market. You don't want to have a large pile of cash sitting around and building little to no appreciation in value.
Remember - the only thing you cannot get back is TIME. So sitting on too large an amount of cash will hinder your growth and miss out on a big part of tax loss harvesting strategy, unless you need that cash for a personal goal or basic living expenses at the moment.
Rebalancing is a critical part of a tax loss harvesting strategy, unless you need that cash for a personal goal or basic living expenses at the moment.
If you are curious to see how tax loss harvesting might fit into a sample financial plan, click here.
Tax loss harvesting is just one investment tactic in your overall investment plan and comprehensive financial plan. It can be a useful tool, or a punishing distraction.
That being said, remember what your goals are.
This is the biggest factor to consider in many of your financial decisions.
Investment income or capital gains are two very different targets and shooting for a lower tax bill shouldn't become your only focus. Of course there are situations where that may very well be your biggest priority.
But the objectives you seek from your investments are catered to your nuanced goals. Keep your goals in focus while you evaluate whether to use tax loss harvesting to offset gains.
The unfortunate reality of investment loss is something that everyone will face. It doesn't have to be purely negative in every case, and shouldn't distract you from the things you set out to accomplish with your broader investing strategy.
Click here to watch a free webinar that will guide you through the 8 financial planning decisions that could help you extend the lifespan of your retirement assets and increase your retirement income by as much as 38%.
Tax loss harvesting can be a great way to reap benefits from tax losses. This a tax strategy that can turn losses into something positive by offsetting gains to minimize taxes.
Short term losses are first matched up to short term gain, which includes ordinary income, up to $3,000 per year and long term losses are first matched up with long term gains.
Remember that income tax brackets are HIGHER than capital gains tax brackets... Taking distributions or harvesting gains from investments that have long term unrealized gains is preferable if you can help it. They will most likely be in a lower tax bracket than short term gain, and lower than your income taxes.
Discuss your desire to tax loss harvest with your tax professional or financial planner before realizing capital losses.
Schedule a free consultation with us to learn how we can help you build a comprehensive financial plan that works.
This depends upon current tax rate and your personal situation. This is a complicated question that can be navigated by some rules of thumb.
What are your personal finance goals?
Will you have a large tax liability from capital gains?
Do you have a diversified pool of assets owned to choose from to take losses and gains?
Plan for future gains when tax planning and consult your tax advisor or financial professional before selling securities in mass, especially if you don't have experience and knowledge regarding tax laws.
You can use capital losses to balance capital gains and decrease capital gains taxes, and even federal income taxes by using the extra net loss to offset income.
Your tax rate is important to consider when choosing what to sell from your investment account.
Short term gain will be taxed at your ordinary income tax rate if you have excess gain.
Typically, the wash sale rule is relevant to substantially identical stock or index funds with the same benchmarks.
You can't buy substantially identical assets, including other forms of securities that can be converted to the same original asset.
Mutual funds offer a way to balance your portfolio while still getting exposure in other areas. Of course, don't purchase mutual funds if they don't match your objectives.
Yes if you owe taxes on your earned income, tax loss harvesting can help lower your tax burden.
However, you must remember that there is a $3,000 net loss allowed per year, and you will have to use the remaining balance (if there is any) in a capital loss carryover to the following year(s) until the net loss is diminished.
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