Unlocking the Power of Tax-Loss Harvesting: A Smart Investment Strategy
Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets. This strategy is commonly used to limit short-term capital gains, often taxed at a higher rate than long-term capital gains, thereby preserving the value of an investor’s portfolio while reducing taxes.
Key Takeaways
- Tax-loss harvesting is a strategy investors can use to reduce capital gains taxes from selling profitable investments.
- A tax-loss harvesting strategy involves selling an asset or security at a net loss.
- You can use proceeds from a sale to purchase a similar asset and maintain the portfolio balance.
How Tax-Loss Harvesting Works
Tax-loss harvesting (or tax-loss selling) is often used by investors at the end of the year when they assess the annual performance of their portfolios and its impact on their taxes. An investment showing a loss in value can be sold to claim a credit against the profits realized from other assets.
This is an effective tool for reducing overall taxes. For instance, a loss in the value of Security A could be used to offset gains from Security B, thereby eliminating the capital gains tax liability of Security B. Implementing this strategy, investors can realize significant tax savings.
If your capital losses for the year exceed your capital gains, you can deduct up to $3,000 in net losses from your total annual income. If your net losses exceed $3,000, IRS rules allow the additional losses to be carried forward into the following tax years.
Maintaining Your Portfolio
Selling an asset at a loss can disrupt the balance of the portfolio. Therefore, after tax-loss harvesting, investors often replace the asset sold with a similar asset to maintain the portfolio’s asset mix and expected risk and return levels. However, it is crucial to avoid buying the same asset just sold at a loss, as doing so may violate the IRS wash-sale rule.
Losses on investments are primarily used to offset capital gains of the same type. Therefore, short-term losses first offset short-term capital gains, and long-term losses first offset long-term capital gains. However, net losses of either type can then be deducted against the other kind of gain.
The Wash-Sale Rule
The wash-sale rule requires investors to avoid buying the same stock sold at a loss for tax purposes within 30 days. A wash sale involves selling one security and quickly purchasing a substantially identical stock or security. If a transaction is considered a wash-sale, it cannot be used to offset capital gains, and violations of this rule can result in fines or trading restrictions.
Using ETFs that track the same or similar indexes can replace one another while avoiding the wash sale rule in a tax-loss harvesting strategy. If you sell one S&P 500 index ETF at a loss, you can buy a different S&P 500 index ETF to harvest the capital loss.
Example of Tax-Loss Harvesting
Assume an investor earns an income of $580,000 in 2023. The investor’s marginal income tax rate is 37% and is subject to the highest long-term capital gains tax category, where gains are taxed at 20%. Short-term capital gains are taxed at the investor’s marginal rate.
Below is the investor’s portfolio gains and losses and trading activity for the year:
Portfolio:
- Mutual Fund A: $250,000 unrealized gain, held for 450 days
- Mutual Fund B: $130,000 unrealized loss, held for 635 days
- Mutual Fund C: $100,000 unrealized loss, held for 125 days
Trading Activity:
- Mutual Fund E: Sold, realized a gain of $200,000 (held for 380 days)
- Mutual Fund F: Sold, realized a gain of $150,000 (held for 150 days)
The tax owed from these sales is:
- Tax without harvesting = ($200,000 x 20%) + ($150,000 x 37%) = $40,000 + $55,500 = $95,500
If the investor harvested losses by selling mutual funds B and C, the tax owed would be:
- Tax with harvesting = (($200,000 - $130,000) x 20%) + (($150,000 - $100,000) x 37%) = $14,000 + $18,500 = $32,500
How Does Tax-Loss Harvesting Work?
Tax-loss harvesting takes advantage of the fact that capital losses can be used to offset capital gains. Investors can utilize capital losses from unprofitable investments to pay fewer capital gains taxes on profitable investments sold during the year. This strategy includes using proceeds from selling unprofitable investments to buy similar investments that preserve the portfolio’s overall balance.
What Is a Substantially Identical Security and How Does It Affect Tax-Loss Harvesting?
Investors must avoid violating the IRS’ wash sale rule by selling an asset at a loss and buying a substantially identical asset within 30 days before or after that sale. This practice invalidates the tax loss write-off. A substantially identical security is defined as a security issued by the same company or a derivative contract issued on the same security.
How Much Tax-Loss Harvesting Can I Use in a Year?
If your capital losses exceed your capital gains, you can claim the lesser of a $3,000 loss ($1,500 if married filing separately) or your total net loss shown on line 16 of Schedule D (Form 1040). If you have a larger net capital loss than that, you can carry the loss forward to later years.
The Bottom Line
Tax-loss harvesting is the timely selling of securities at a loss to offset capital gains tax owed from selling profitable assets. An individual taxpayer can write off up to $3,000 in net losses annually. For more advice on maximizing your tax breaks, consider consulting a professional tax advisor.
Related Terms: capital gains tax, portfolio management, wash-sale rule.
References
- Internal Revenue Service. “Topic No. 409, Capital Gains and Losses”.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”. Pages 56-57.
- Internal Revenue Service. “Publication 550: Investment Income and Expenses”. Pages 65-66.
- Internal Revenue Service. “Federal Income Tax Rates and Brackets”.
