What Is Tax-Loss Harvesting?

What Is Tax-Loss Harvesting?

Tax-loss harvesting means deliberately selling stocks or securities at a loss to offset capital gains and income.

Capital gains occur when you sell assets for more than you paid for them. Capital gains are taxed at short-term rates of 0% to 37% or long-term rates of 0%, 15% or 20%, depending on your taxable income and how long you've held the asset. Capital losses reduce your taxable gains, lowering your tax bill and effectively raising your net return on your investments. Capital losses can also be used to offset up to $3,000 in regular income. Any excess loss can be carried over to future years.

Learn more: What Is Capital Gains Tax?

How Does Tax-Loss Harvesting Work?

There are three main steps to make tax-loss harvesting work for you.

1. Identify Investments You Can Sell at a Loss

Check your cost basis, or the amount you paid for the investment, as well as your date of purchase to find potential short- or long-term capital losses.

Investments you've held for more than a year create long-term capital losses; investments you've held for a year or less create short-term losses.

2. Use Capital Losses to Lower Your Tax Bill

You'll report capital gains and losses on your individual tax return, Form 1040. To use capital losses to offset capital gains and other income, follow these basic steps:

• Use Form 8949 to categorize and list your short- and long-term capital gains and losses.
• Use Schedule D to calculate your net short- and long-term capital gains or losses.
• Use Form 1040 to report your net capital gain or loss, and to deduct up to $3,000 ($1,500 if married filing separately) from regular income (line 7a).

Learn more: Can You Deduct a Capital Loss on Your Taxes?

3. Reinvest Funds

Meanwhile, don't forget to put your money back to work by reinvesting. Your new investments must be substantially different from the investment you sold, according to the wash sale rule explained below.

Tax-Loss Harvesting Example

Here's a quick and simple example of how tax-loss harvesting might help you save money on your taxes, improve your return on investment and strengthen your portfolio:

Example: You're ending the year with capital gains of $20,000 and you'd like to harvest losses to help lower your tax bill. You decide to sell underperforming stock shares for $15,000, creating at a capital loss of $32,000.

• Your capital loss offsets your gain completely. $20,000 - $32,000 = a net capital loss of $12,000. If you're in the 24% tax bracket, you would have paid $4,800 in short-term capital gains tax on your $20,000 gain without tax-loss harvesting, or $3,000 (15%) if you had long-term gains and no loss.
• You can deduct $3,000 of your $12,000 remaining loss from your regular income. At 24%, that saves you $720.
• You can carry the remaining $9,000 loss over to offset capital gains and income in future years. Your loss applies the same way in future years: against capital gains first, then regular income.

You can reinvest the $15,000 you received from the sale of your losing investment in a new stock you hope will perform better. You can also invest all or some of your tax savings to grow your portfolio even further.

Tax-Loss Harvesting Rules

Keep these rules in mind if you're considering tax-loss harvesting.

Wash Sale Rule

According to the wash sale rule, you can't deduct a capital loss if you buy the same stock or security within 30 days. The rule also prohibits receiving a "substantially identical" stock or security in a taxable trade, acquiring it as part of a contract or option to buy, or adding it to your IRA or Roth IRA, also within a 30-day window.

"Substantially identical" securities might include, for instance, two index funds that each follow the S&P 500.

Capital Losses Offset Capital Gains First

Capital losses offset capital gains before they apply to regular taxable income. You can use an unlimited amount of capital loss to offset capital gains, but you can only deduct up to $3,000 in capital loss from your regular income. For these reasons, capital losses may be most useful when you have capital gains to offset.

State Taxes May Apply

Check with your state taxing authority for rules on capital gains and losses. Nine U.S. states—Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming—don't have personal income taxes, though Washington state does have a 7% capital gains tax for high-income earners.

Pros and Cons of Tax-Loss Harvesting

Tax-loss harvesting has strategic—and financial—benefits, but it's not without its risks and limitations. Here are pros and cons to think about:

Is Tax-Loss Harvesting Worth It?

Tax-loss harvesting is most worthwhile when it saves you significantly on taxes and helps prune your investments for healthier growth and performance. Though anyone can consider these benefits, here are a few signs that tax-loss harvesting might work especially well for you:

• You're in a high tax bracket: Claiming a loss can save you money on taxes even with a modest income, but being a higher tax bracket increases your savings.
• You have short-term capital gains: A capital loss can offset either long- or short-term capital gains. However, since short-term capital gains may be taxed at higher rates (up to 37%), eliminating short-term gains may be more beneficial.
• You have lackluster investments: Not only can you rid yourself of bad investments, but you can also trade off middling performers for investments with greater earnings and growth potential, or less risk.
• You need to rebalance your portfolio: Over time, investments grow at different rates. If you're trying to maintain a specific allocation of assets, such as 20% of your portfolio in bonds and 80% in stocks, selling assets strategically helps keep your portfolio in balance.

The Bottom Line

Nothing puts a damper on celebrating capital gains like having to pay capital gains taxes. Using tax-loss harvesting can help you minimize your tax bill and, hopefully, build a bigger, stronger portfolio in the process. Though the idea of tax-loss harvesting is relatively simple, choosing the right investments and navigating tax requirements can be challenging. Getting help from a financial advisor or tax pro may help you score a win from the loss column as painlessly as possible.