What Is Tax-Loss Harvesting?

Key Takeaways

• Tax-loss harvesting is a tax strategy where investors sell securities at a loss to offset capital gains taxes from other profitable investments. 
• While tax-loss harvesting is a smart way to reduce your tax bill, there are rules and nuances that investors should be aware of, like the wash-sale rule.
• Financial advisors can help integrate tax-loss harvesting into investors’ overall wealth management plan, implement it in compliance with IRS rules, and take on the time-consuming work of continuous portfolio monitoring and management.

When it comes to smart investing, minimizing taxes is a key consideration towards maximizing returns. One powerful strategy that savvy investors—and their wealth advisors—use to enhance after-tax performance is tax-loss harvesting.

By strategically selling underperforming investments to offset capital gains, tax-loss harvesting can help reduce your overall tax bill. However, tax-loss harvesting involves rules and considerations that investors should understand before diving in.

In this article, we explore how tax-loss harvesting works, the rules, and why it’s beneficial to work with an advisor to implement it.

What Is Tax-Loss Harvesting?

Tax-loss harvesting is a tax strategy where investors sell securities at a loss to offset capital gains taxes from other profitable investments. 

The mechanics of tax-loss harvesting are relatively straightforward:

1. Sell: Find underperforming assets and sell them at a loss to offset taxable capital gains.
2. Reinvest: Invest in different assets that align with your financial goals to maintain your target portfolio allocation and risk profile.
3. Deduct: If losses exceed gains, deduct up to $3,000 of net losses against ordinary income annually.

Investors can replace the asset they sold at a loss with a comparable asset, but it’s crucial to avoid buying back the same or a “substantially identical” security within 30 days before or after the sale to comply with the IRS wash-sale rule (more on that below).

Example Scenario

Let’s say you own two stocks in your taxable brokerage account:

• Stock A: Realized gain of $30,000
• Stock B: Unrealized loss of $20,000

If you sell Stock B, you can use that $20,000 loss to offset $30,000 of your gain from Stock A. That means you’ll only pay taxes on $10,000 in net capital gain instead of the full $30,000.

If your capital losses exceed your capital gains, you can deduct up to $3,000 of the losses to offset your ordinary income – and can carry forward any remaining losses to offset future capital gains indefinitely.

Tax-Loss Harvesting Rules & Considerations

Tax-loss harvesting is a smart, strategic way to reduce your tax bill.

However, while it’s simple in concept, there are rules and nuances that investors should understand and evaluate to consider whether and how they implement it. 

• Taxable Accounts: Tax-loss harvesting only applies to investments in taxable accounts. You cannot apply it to tax-deferred accounts like IRAs, 401(k)s, 403(b)s, or 529s. Keep in mind that any reduction in taxes depends on an investor’s specific tax situation.
• End of Year Deadline: Investors must complete all tax-loss harvesting before the end of the calendar year. It’s recommended to complete all trades well in advance of December 31 to ensure they settle in time to be included.
• Carryforwards: Some states’ tax regulations do not allow loss carryforwards, in which case the benefits of tax-loss harvesting may be limited. Check your state’s laws and consider consulting a financial advisor or tax professional before implementing tax-loss harvesting.
• Tax Bracket: Tax-loss harvesting is especially worthwhile if you’re in a high tax bracket (because the higher your tax bracket, the bigger your potential savings) or if you’re on the cusp of a lower tax bracket. On the other hand, if you’re in a low tax bracket or don’t have significant capital gains, the benefits may not be worth the effort.

IRS Wash-Sale Rule

The most important tax-loss harvesting rule investors should know is the wash-sale rule.

Under the wash-sale rule, the IRS prohibits investors from claiming a loss if they sell an investment at a loss and then buy the same or “substantially identical” investment within 30 days (also known as a “wash sale”). 

For example, an investor who sold a stock resulting in a capital loss of $1,000 cannot repurchase that stock two weeks later and still claim that $1,000 loss on their taxes to offset ordinary income or capital gains.

This rule applies to purchases across all accounts, including brokerage accounts, retirement accounts, and even spouses’ accounts. This prevents investors from skirting the wash-sale rule by selling an investment in their brokerage account for a loss and then repurchasing the same investment in their 401(k), for example.

In order to avoid wash sales, investors should wait at least 31 days before buying back the same security. They can also consider replacing the sold investment with an ETF or mutual fund in the same industry.

Benefits of Working with an Advisor

While tax-loss harvesting can be a valuable strategy, executing it effectively requires more than just selling losing investments. Timing, security selection, tax regulations, and portfolio rebalancing all play a role – and mistakes like triggering a wash sale can eliminate the benefit entirely.

That’s where working with a financial advisor can add significant value. Partnering with an advisor provides for:

• Holistic Plan: Advisors can integrate tax-loss harvesting into your broader wealth management plan, aligning it with your overall risk tolerance, goals, and time horizon.
• Monitoring: Unlike one-time, year-end efforts, advisors can take on the time-consuming work of monitoring your portfolios continuously to capture opportunities throughout the year.
• Compliance: Advisors are aware of, and can ensure you’re in compliance with, IRS rules to avoid costly mistakes like wash-sale violations.
• Reinvestment: Advisors can guide you in selecting alternative investments that maintain your portfolio’s intended exposure while staying within IRS guidelines.

Summary

Tax-loss harvesting is a smart, strategic way for investors to reduce their tax bill.

However, before implementing, investors should understand the rules and consider working with a financial advisor to stay compliant and ensure alignment with their overall financial plan.