Even great investors like Warren Buffett and Peter Lynch sometimes buy losing stocks that only seem to go down. To be a profitable investor, you only have to buy more winning securities than losing securities, but inevitably there will be capital losses in any investor’s portfolio. While having a diversified portfolio will help minimize your portfolio’s risk, don’t become discouraged if you pick some bad companies. Fortunately, a losing investment doesn’t have to be all negative. Under the U.S. tax system, you can use your losses to lower your tax bill by utilizing a tax loss harvesting strategy.
We’ll review everything you need to know about tax loss harvesting and how it can cut your overall tax liability.
Tax loss harvesting or tax loss selling is when you sell your investments at a loss to offset capital gains from other investments sold at a profit. In short, you only need to pay taxes on your net profit, or the amount you gained minus the losses, thus lowering your tax bill.
You can harvest losses on various investments, including stocks, bonds, commodities, exchange-traded funds (ETFs), mutual funds, and even cryptocurrencies. Additionally, if you realize net capital losses, the Internal Revenue Service (IRS) allows you to claim up to $3,000 net loss annually against your ordinary income, so it’s often a smart idea to take advantage of this tax strategy if you have loses in assets you no longer believe will bounce back.
Tax loss harvesting is a frequently used strategy of financial advisors used to reallocate the value of an investor’s portfolio while minimizing taxes by offsetting short-term capital gains, which are taxed at a greater rate than long-term capital gains.
When done correctly, tax-loss harvesting enables you to control and lower your tax liability by selling investments at a loss to offset the taxes due on capital gains from other investments.
Tax-loss harvesting is a strategy most investors employ when evaluating their portfolios’ annual performance and its effects on taxes.
Selling an underperforming investment allows you to offset the gains made on other assets. You can use the tax-loss harvesting approach and get considerable tax savings.
Before using tax-loss harvesting, you must know how capital gains taxes operate. An investor earns a “realized” taxable capital gain when they sell an investment in a taxable account for more value than what they spent.
Profits from investments you’ve held for more than a year are taxed at the long-term capital gains rate, which can range from 0% to 20% depending on your income, as opposed to profits from investments you’ve held for less than a year, which are taxed at your regular ordinary income rate.
Tax harvesting can help you reap tax savings in that situation. For example, you can leverage the loss from the sale of an investment to reduce any gain you might otherwise have to pay taxes on.
The IRS requires first matching long-term losses to balance long-term profits and short-term losses to offset short-term gains. Any excess losses can then be used to offset gains in both short-term and long-term gains.
If your losses continue to outweigh your gains after that, you could use up to $3,000 of your net loss to offset ordinary income. Any additional losses must be carried over as future losses to be used in a subsequent tax year. Losses can be carried forward an unlimited number of years until they can be used to offset realized taxable capital gains.
Tax-loss harvesting typically works like this:
- You sell an investment that is underperforming and losing money,
- Use the loss to offset up to $3,000 of your income and lower your taxable capital gains, and then
- Reinvest the proceeds in a new security that satisfies your investing needs and asset-allocation strategy.
Although the idea behind tax-loss harvesting is straightforward, you should avoid some potential traps.
Harvesting tax losses isn’t a good idea for everyone. So here’s what you should know before you utilize the strategy to lower your tax bill.
The IRS wash-sale rule provides that if you sell an investment to deduct a loss for tax reasons, you cannot buy back the same or another “substantially identical” asset for 30 days.
You cannot also go around the wash-sale rule by buying back the asset you sold in another account, such as an individual retirement account (IRA).
Some investors try to manipulate the tax-loss harvesting strategy by plotting to sell investments at a loss at the end of the year and then buying them at the start of the following year when they may have recovered.
To prevent that, the IRS has put the wash sale rule in place to deter those who want to sell and buy back to avoid capital gains taxes.
Whenever you sell an asset, you must record your cost basis as part of filing your tax returns; however, most U.S. brokers handle this process, reporting your proceeds and cost basis directly to the IRS and send a condensed Form 1099.
Many factors influence your cost calculation, including the nature of your investment, the computation method, and how you obtained your investment.
The IRS maintains that it’s your responsibility to accurately disclose your cost basis when filing your taxes. Therefore, it is vital to have a basic understanding of how to do it so that you can spot tax-saving opportunities when they present themselves.
The cost basis of an asset is the price you paid for it when you bought it. For example, when you buy an asset such as property, stocks, or mutual fund, your cost basis calculation is the investment cost you incurred when you purchased it.
Keeping track of your cost basis will allow you to calculate your potential profit or loss should you decide to sell the investment.
The cost is then compared to the price at which the fund shares were sold to determine the tax-reporting gains or losses.
The average cost is determined by dividing the amount invested in a mutual fund position in dollars by the number of shares owned. For example, if you invest $20,000 and hold 1,000 shares, the average cost basis calculation is $20 ($20,000/1000).
The IRS generally taxes capital gains (money made from investments) depending on whether it’s long-term or short-term.
Long-term capital gains are taxed at a lower rate than short-term capital gains. These are investments that you’ve had for more than a year. Long-term capital gains are taxed at 0%, 15%, or 20%, depending on income level. In many cases, taxpayers who declare long-term capital gains pay 20% or less in taxes, plus a surcharge for the Affordable Care Act (ACA) of 3.8%, which is charged on all investment income for high-income earners.
Short-term capital gains are subject to the same taxation as earned ordinary income. As a result, they are taxed at a significantly higher rate than long-term gains. This classification applies to assets and investments that have been held for less than a year.
Short-term capital gains are subject to regular income taxation. Based on your tax bracket, that rate could rise to 37% in 2023.
Tax harvesting is not less relevant for tax-deferred retirement accounts such as 401(k), 403(b), 529, and Individual Retirement Accounts (IRAs). Because deferred retirement accounts do not require annual taxes, tax loss harvesting is not commonly practiced or necessary in these types of accounts independently.
If you currently fall into a lower tax bracket and believe you’ll be in a higher one in the future, you may not choose not to tax loss harvest today but instead wait until the future when the tax savings are more significant. By delaying your capital losses, you can defer the higher rates on your gains once you reach a higher tax bracket.
If you expect that your income will be reduced in the future, such as someone nearing retirement, tax loss harvesting is even more beneficial because the strategy will save you more tax dollars at higher rates.
You can even use tax gain harvesting and sell investments at a profit when the tax rate is very low or even zero and then repurchase them after the wash sale period. Furthermore, you can immediately purchase a similar, but not identical, security, such as replacing a passive ETF with another ETF tracking a different index. Swapping assets will cause your investment’s cost basis to be reset, which is the fundamental goal behind tax loss harvesting or tax gain realization strategies.
There is no wash sale rule for selling at a profit. You can sell and quickly repurchase the investment.
Tax-loss harvesting is an intelligent strategy for most individuals and will save you tax dollars.
Keeping up with the latest investment trends is essential when deciding whether or not tax-loss harvesting is a good idea. Tax-loss harvesting is ideal when done alongside portfolio rebalancing.
Here are situations when and not to use Tax loss harvesting.
Tax-loss harvesting is convenient when it fits your overall long-term investing strategy. Think of tax-loss harvesting as a consolation prize for an investment misstep that is inevitable even for the most successful investors.
Here are some scenarios to consider when considering tax loss harvesting.
Tax-loss harvesting does not apply to tax-deferred retirement funds such as IRAs, 401(k), and 403(b) accounts. If you have other investment accounts subject to capital gains taxes, consider this strategy to decrease your tax liability.
Tax-deferred retirement plans allow you to defer paying taxes until retirement age. Using tax-efficient retirement plans, coupled with diversified portfolio investing and tax-loss harvesting, will reduce your tax liabilities.
If you’re now in a lower tax bracket and believe you’ll be in a higher one, you may want to explore different strategies instead. Nevertheless, tax loss harvesting will still function, but it may be more favorable to use the losses in the future.
By deferring your capital gains taxes, you may pay higher rates on those earnings once you reach a higher tax bracket, but of course, the market is unpredictable in the short run, and unrealized gains may not be profits in the future.
Tax-loss harvesting is a good option if your assets are in individual equities or exchange-traded funds (ETFs). However, it might be more challenging if your investments are primarily in mutual funds.
The main difference between mutual funds and ETFs is that ETFs are actively traded on the stock exchange.
When it comes to tax-loss harvesting, ETFs have an edge since they provide a way for investors to avoid the wash-sale rule when selling assets. ETFs track various indexes and sectors of the market and can be easily traded simultaneously to reallocate positions intraday.
Even if you don’t have any investment gains to offset, you can harvest your losses to balance other income and reduce your taxes in the future. Remember that investing is a long-term undertaking that requires some patience.
Savvy investors exploit bad years and poor investments as a tool to harvest losses and use them for taxable gain offsets in the future.
Worst case scenario, you can always take $3,000 of your losses against your annual income to perpetuity even if you don’t recognize gains for many years.
Tax-loss harvesting can be a good investment and tax-planning approach. However, not all losses should be harvested. Here’s when tax loss harvesting may not be ideal.
Tax loss harvesting is not worth it if it does not provide enough tax savings to at least offset the trade cost. With most online brokers charging little to no trading fees these days, there is no reason you should be paying significant transaction costs for any stocks or ETFs. Trading fees can be more concerning if trading illiquid bonds, physical commodities, real estate, or other illiquid securities. Implicit costs such as commissions or significant bid-ask spreads of exchange-listed securities should be included in estimated total trading costs.
When the Market Is Volatile
If the markets are volatile, ensure you know that you are selling your asset at a lower price than you paid when executing your harvesting.
Otherwise, you risk incurring unanticipated taxes from the gains you make when you make the sale — which would be contrary to the entire strategy and cause a detriment to your owed taxes.
If the market appears particularly volatile and your losses are minimal, you should consider waiting to harvest losses until you can be sure your executions will be made at predictable prices.
Well-executed tax-loss harvesting should never affect your long-term investment plan. Instead, it should reduce the basis of your portfolio and minimize taxes once completed, resulting in a greater future capital gains taxes liability.
Even as you look at specific tax-loss harvesting opportunities, you must maintain your broader tax-planning goals in mind. For example, you should only sell out a losing position if you can reinvest the money immediately in a similar index, company, or strategy that fulfills your long-term vision.
Remember that tax-loss harvesting only works for holdings and investments in taxable accounts. If your investment is in tax-sheltered accounts that do not produce taxable gains or losses, you cannot tax-loss harvest these losses against your current year’s taxes.
Never sell an investment if there’s a better option. Harvesting tax losses is a secondary optimization strategy that should occur after your investment goals. Keeping the asset is the best option if you can’t locate a comparable investment to replace it or believe the security will recover and improve in value very soon.
Selling an investment for tax reasons, if it is losing money, is generally an uncomfortable idea, and therefore inexperienced investors sometimes hold positions too long. However, tax-loss harvesting can be an essential part of your overall financial planning and investing strategy, and it should be one of your strategies for optimizing your taxes and reaching your financial goals. Take advantage of a tax-loss harvesting strategy by checking your portfolio for opportunities at least once per year, but ideally, you should be looking once per quarter and always once before the end of the tax year in December.
Josh is a financial expert with over 15 years of experience on Wall Street as a senior market strategist and trader. His career has spanned from working on the New York Stock Exchange floor to investment management and portfolio trading at Citibank, Chicago Trading Company, and Flow Traders.
Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business. He has held multiple professional licenses during his career, including FINRA Series 3, 7, 24, 55, Nasdaq OMX, Xetra & Eurex (German), and SIX (Swiss) trading licenses. Josh served as a senior trader and strategist, business partner, and head of futures in his former roles on Wall Street.
Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh currently holds areas of expertise in investing, wealth management, capital markets, taxes, real estate, cryptocurrencies, and personal finance.
Josh currently runs a wealth management business and investment firm. Additionally, he is the founder and CEO of Top Dollar, where he teaches others how to build 6-figure passive income with smart money strategies that he uses professionally.