Tax loss harvesting is a strategy used by investors to reduce their tax burden by taking losses on one investment to offset the capital gains earned on other investments.
Pros and Cons of Tax Loss Harvesting
|Can reduce or eliminate capital gains taxes on successful investments.||Every trade incurs transaction fees.|
|Great for long-term investors who are happy to buy back shares that are devalued and wait for the market to correct.||There is the potential to miss out on gains if you do not reinvest properly.|
|Is a good opportunity to ensure you hold only stocks that fit your strategy.||Requires good planning and typically the aid of a professional financial advisor or robo-advisor.|
|Robo-advisors can be used to execute this strategy, which is a cheaper option than a traditional advisor.||IRS regulations can make it complicated (see Wash Sale rule below).|
How it works
While no one wants to lose money, most investors end up making a bad bet at least once in a while. A well-diversified portfolio will typically include some assets that decrease in value while others increase.
By using the tax loss harvesting strategy, you can actually make losses work in your favor.
- Assume you invest in two stocks and two years later you find that they have changed value:
Stock A: Decreased in value by $100,000
Stock B: Increased in value by $120,000
- Since you’ve held both investments for more than a year, they are taxed at the long-term capital gains rate.
- The rate that applies to you depends on your marginal income tax bracket:
- Assume you fall into the 25% marginal tax bracket, so your long-term capital gains rate is 15%.
- If you sell Stock B but not Stock A, you will have locked in, or “realized,” $120,000 of gain.
- Your $100,000 loss on Stock A will remain “unrealized” until you sell it.
- Since you only sold Stock B, you only have gain, which is all taxable at your 15% rate:
- $120,000 * 15% = $18,000
- However, if you sold both stocks, you would have realized both a $120,000 gain and a $100,000 loss. The loss can be used to offset the gain and reduce your tax bill:
- ($120,000 – $100,000) * 15% = $3,000
Crucial second step
Shrewd investors take the tax loss harvesting strategy one step further by reinvesting the money they pull out of their “failed” investments.
Consider the difference in these two scenarios:
- Buy Stock A for $100,000.
- Eighteen months later, the investment is only worth $60,000.
- Hold onto it and wait for the market to correct.
- After another six months, it has bounced back and is now worth $200,000.
- Buy Stock A for $100,000.
- Eighteen months later, the investment is worth $60,000.
- Sell Stock A, “harvesting” the $40,000 tax loss.
- Take the $60,000 you pulled out of Stock A, and reinvest it right back into Stock A, thereby maintaining the same market exposure. If you do this quickly, you should be able to buy about the same number of shares you had originally due to their reduced value.
- After another six months, the stock has bounced back and is now worth $200,000.
In both cases, you invest $100,000 and end up with an investment worth $200,000. BUT, in Scenario 2, selling Stock A when the value plummets means that come tax time you can apply that $40,000 tax loss to any capital gains earned on other investments.
Good to know
Short- and Long-Term Gains
If you have some assets that you’ve held for less than a year and some you’ve held longer, different capital gains tax rates apply, so be sure to account for the applicable rate when calculating the potential tax savings of selling a given investment at a loss.
Applying Losses to Income
If you have more losses than gains in a given year, you can apply up to $3,000 in capital losses to offset your regular income, reducing your tax burden even further.
Carry Over Losses
If your losses are greater than your gains in any given tax year and you’ve maxed out the income deduction, you can carry forward excess losses to the next tax year.
The IRS does not allow you to claim a capital loss deduction on your taxes if you reinvest funds pulled out of one stock into the same stock or one that is “substantially identical” right away. You can’t sell Stock A and then repurchase it the next day, for example—this is called a “wash sale.”
- The wash sale period extends back from 30 days prior to the day you sell your stock to 30 days after the sale.
- The full wash sale period, therefore, is 61 days, not just 30.
If you don’t want to wait 61 days to dive back into the market, you can get around the wash sale rule by reinvesting into a different stock that is “highly correlated” to the stock you sold. In the stock market, correlation simply means that two stocks behave the same way with a high degree of reliability. If Stock C tends to increase at the same rate and at the same times as Stock A, you could sell Stock A to lock in a loss and then reinvest into Stock C right away to maintain nearly identical market exposure without missing a beat.