When it comes to managing investments, most people are familiar with the idea of making money by buying low and selling high. But there’s another, lesser-known strategy that can help you minimize your tax liability and keep more of your hard-earned cash. It’s called tax-loss harvesting. While it may sound complicated, tax-loss harvesting is actually a straightforward way to reduce your taxable income and lower the amount of taxes you owe, especially in years when your investments aren’t performing as well as you’d hoped.
Let’s break it down and see how this strategy can work for you.
What Is Tax-Loss Harvesting?
At its core, tax-loss harvesting involves selling investments that have lost value in order to offset gains you’ve made in other parts of your portfolio. Essentially, you’re taking advantage of capital losses to reduce your taxable income. In the U.S., the IRS allows you to use your capital losses to offset capital gains, meaning if you sell an investment for less than you paid for it, you can use that loss to reduce the tax burden on any gains you’ve made from other investments.
If your losses exceed your gains, you can even apply up to $3,000 of the loss against your ordinary income (like your salary or business income). Anything above that can be carried forward to future tax years, allowing you to continue lowering your tax bill for years to come.
Now, let’s explore the key reasons why tax-loss harvesting could be a game-changer for your financial situation.
Reducing Your Taxable Income
One of the biggest advantages of tax-loss harvesting is its ability to reduce your taxable income. In the U.S., when you sell investments that have appreciated in value, you’re required to pay capital gains tax on the profit. However, by selling investments that have declined in value, you can offset those gains with your capital losses, effectively lowering your taxable income.
For example, let’s say you sold some stocks earlier in the year and made a profit of $5,000. Then, toward the end of the year, you sell another stock for a loss of $3,000. In this case, the $3,000 loss will offset part of the $5,000 gain, meaning you’ll only owe taxes on $2,000 of that gain. This simple strategy can save you hundreds—or even thousands—of dollars in taxes.
Moreover, if your losses exceed your gains, you can use the excess loss to offset up to $3,000 of other income, such as wages or self-employment income. If your total loss exceeds $3,000, it can be carried over to future years, allowing you to continue using it to offset gains or income down the road.
Lowering Capital Gains Taxes
Another big win of tax-loss harvesting is its ability to reduce your capital gains tax liability. Capital gains taxes are taxes you pay on the profit from the sale of an investment. If you hold an asset for more than a year before selling it, you’ll generally be taxed at a long-term capital gains rate, which is lower than the rate for short-term gains (for assets held less than a year). The long-term rate can be as low as 0%, depending on your income, and the highest rate is typically 20%.
However, the capital gains tax can still eat into your profits, especially if you’ve made significant gains. Tax-loss harvesting helps to reduce these taxes by offsetting your taxable gains with losses. By strategically selling underperforming investments to capture capital losses, you can reduce the amount of capital gains tax you owe. This is particularly beneficial for individuals who are in a higher tax bracket, as the savings can add up quickly.
Carrying Forward Losses for Future Tax Years
A lesser-known benefit of tax-loss harvesting is the ability to carry forward capital losses to future years. If you have more losses than gains in a given year, you can use the excess losses to offset future capital gains. This means that even if you can’t use all of your losses in the current year, you can apply them in the future to reduce your taxes when you have gains.
For example, if you have a $10,000 loss in one year and no gains to offset it against, you can carry that loss forward and use it in the next tax year to offset any gains you might realize. There’s no expiration date on these losses, so you can carry them forward indefinitely until they’re used up. This is a huge benefit for investors who may experience good years and bad years in the stock market—tax-loss harvesting allows you to keep your tax situation under control for the long term.
The Wash-Sale Rule
While tax-loss harvesting can be an excellent way to reduce your taxes, there are a few rules you need to be aware of. The most important rule to keep in mind is the wash-sale rule. This rule states that if you sell an investment at a loss and then repurchase the same or a substantially identical security within 30 days, the IRS will disallow the loss. In other words, you can’t sell an investment for a loss and immediately buy it back to claim the loss for tax purposes.
To avoid violating the wash-sale rule, you can either wait 31 days before repurchasing the same investment or invest in a similar but not identical asset (such as buying a different stock or an ETF that tracks a similar sector). The wash-sale rule ensures that people aren’t taking advantage of tax-loss harvesting by essentially making the same investment again immediately after selling.
The Importance of Timing
Timing is another important factor when it comes to tax-loss harvesting. Generally, you’ll want to harvest losses toward the end of the year, after you’ve had a chance to assess your portfolio and determine whether any investments have underperformed. However, the timing also depends on your personal financial situation and your tax bracket.
If you’re in a low tax bracket and won’t benefit much from offsetting capital gains, it might not make sense to sell investments at a loss. On the other hand, if you’re in a high tax bracket, harvesting losses could be more beneficial, as it would significantly reduce your taxable income and lower your tax liability.
It’s also important to consider your overall investment strategy when harvesting losses. If you’ve sold an investment for a loss, make sure it aligns with your long-term financial goals. Selling a stock or bond just to capture a tax break may not always be the best choice if it’s not in line with your strategy.
Who Should Consider Tax-Loss Harvesting?
While tax-loss harvesting can be beneficial for many investors, it’s not necessarily right for everyone. This strategy is best suited for people who have a diversified portfolio with both gains and losses in different assets. If your portfolio has mostly appreciated assets, you may not have enough capital losses to make tax-loss harvesting worthwhile. On the other hand, if you’ve experienced a year where many of your investments have dropped in value, tax-loss harvesting could help you offset those losses with any gains you’ve made, potentially saving you a significant amount in taxes.
It’s also important to have a long-term mindset when it comes to tax-loss harvesting. While it can provide short-term tax savings, the ultimate goal of investing should always be to build wealth over time. Don’t let tax-loss harvesting lead you to make hasty decisions that might hurt your portfolio in the long run.
Final Thoughts
In conclusion, tax-loss harvesting is a powerful tool that can help you reduce your tax liability, lower your capital gains taxes, and keep more of your investment returns. By carefully selecting investments to sell at a loss, you can offset gains, reduce your taxable income, and even carry forward losses to future years. Just make sure to be aware of the wash-sale rule and consider the timing and long-term impact of your decisions.
If you’re unsure whether tax-loss harvesting is right for you, consider working with a financial advisor or tax professional who can help you navigate the strategy and ensure it’s implemented correctly. With a little planning and attention to detail, you can take advantage of tax-loss harvesting and make it a valuable part of your overall investment strategy.