Tax-loss harvesting takes poorly performing securities and sells them to realize a capital loss that can offset any realized capital gains on other profitable securities sold.
What Is Tax-Loss Harvesting?
Tax-loss harvesting is a tax strategy performed by investors who want to reduce capital gains taxes. In tax-loss harvesting, investors sell securities that are down below their cost basis to offset gains made from securities sold above their cost basis.
How A Tax-Loss Harvesting Strategy Works
A tax-loss harvesting strategy involves examining the holdings in a portfolio and seeing what has been sold for a profit in the current tax year. Investors will select the securities that have lost money and sell them to offset the gains made in the sale of other securities.
Tax Harvesting Individual Stocks vs. Funds
Tax-loss harvesting is commonly seen in portfolios with stock holdings but can be done with other securities such as bonds, options, ETFs, and mutual funds. Mutual fund advisors may perform their own tax-loss harvesting within the fund to help investors offset the capital gains that the fund generates. Remember that investors in mutual funds realize a capital gain or loss every time a money manager sells a security in the fund.
Those who invest in ETFs can sell one ETF for a loss and invest in a new ETF with the same underlying index and not violate the wash sale rule. This is one way to harvest tax losses without losing the fundamental position in the portfolio.
Note: The wash-sale rule restricts investors from selling an investment for a loss and buying an identical investment for 30 days.
Tax Harvesting in a Robo Advisor Account
Robo advisors take a lot of the guesswork out of investing and rely on algorithms and automation to make key investment decisions. Many Robo advisors also perform automatic tax-harvesting that does not violate the wash sale rule. This helps keep the fund tax-efficient.
Capital Gains Tax-Loss Harvesting Rules
When you are tax-loss harvesting, there are some rules to keep in mind. Failure to follow the rules can result in the loss not being realized on tax returns. Since most investors harvest losses for the purposes of taxes, following the rules is essential.
Annual Limit to Harvesting Tax Losses
In general, tax losses can offset any capital gains that you have. However, even if you don't have capital gains to report, you can tax loss harvest to lower your tax bill. You can report up to $3,000 per year in losses and offset income. Those who are married filing separately can only deduct $1,500 in losses.
Last Day to Tax-Loss Sell
Investors have until the last day of the year to perform a tax-loss sale. If the market is open on December 31, this is the last day to sell the security. Otherwise, the last day is the last applicable market day. Sales after this are moved into the new year for tax-loss purposes.
The Wash-Sale Rule
The wash-sale rule says that you cannot take a loss on a security and then buy it or a substantially similar security back within 30 days. The IRS prohibits this because when it is done, the portfolio has no substantial change, and it is viewed only as a way to get out of paying capital gains.
Benefits & Limitations of Harvesting Tax Losses
Benefits of Tax-Loss Harvesting
- Offset capital gains dollar for dollar
- Offset income up to $3,000 in losses
- Reduce overall tax liability
- Can be carried over to future years
Limitations of Tax Harvesting
- Limited to $3,000 per year above realized capital gains
- Can't repurchase the same security for 30 days
- Must be sold within calendar year
Tax-Loss Harvesting Example
Assume that an investor has sold investments, realizing a long-term capital gain subject to the 20% tax rate. The investor sold:
1,000 shares of ABC stock bought at $50 per share and sold for $80 per share for $30,000 capital gain
1,000 shares of XYZ stock bought for $75 per share and sold for $100 per share for a $25,000 capital gain
The investor has $55,000 in long-term capital gains which means they would pay 20% in taxes on it, or $11,000.
But if the investor has stocks that they can sell at a loss, they can offset gains. They look at their portfolio and sees the following holdings:
1,000 shares of EFG stock bought at $55 per share and currently trading at $30 per share for a loss of $25,000
1,000 shares of QRS stock bought at $100 per share and currently trading at $60 per share for a loss of $40,000
The investor sells both positions to harvest the tax losses. They have a total of $55,000 in long-term capital gains and $65,000 in capital losses. The investor has successfully offset their gains and has $10,000 in additional capital losses. Due to the tax loss harvesting limit, the most they could offset their income with is another $3,000.
Tax-Loss Harvesting To Increase Returns
Not all stocks perform the way they are intended, leaving investors with the option to realize capital losses to offset any capital gains. This helps increase returns over time as investors can then get money working on new investments to realize more gains.
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