Tax-loss harvesting is undoubtedly worth the effort in most cases (but not all). If done correctly, tax-loss harvesting can lead to higher overall portfolio returns. Yet, most investors do not implement this strategy. We’re not sure why, but most investors are either unaware of the strategy or do not understand it well enough to implement it. Either way, this guide should help you understand the basics of tax-loss harvesting so that you too, can take advantage of its benefits.
What is Tax-Loss Harvesting?
In its simplest form, tax-loss harvesting is selling an investment at a loss now to offset any gains (now or in the future). This strategy of offsetting gains via losses can save you from paying some or all of any taxes due to the investment gains.
The trick, though, is doing all of this before the end of the year. If you are looking to take advantage of realizing any losses for 2023, you have to realize an investment loss during 2023. It’ll be too late if you wait until April (or October) of 2024.
Tax-loss harvesting applies only to investments owned within taxable accounts, not retirement accounts like 401(k)s or IRAs, as retirement accounts are either tax-deferred or tax-free.
Quick disclaimer here – taxes arewildlycomplicated. To talk about tax-loss harvesting, I first have to talk about capital gains taxes. I only go over the basics to provide an overview, but know that many complications can occur when dealing with investment gains and income, such as AMT and Medicare surtaxes. Know that I only go over taxes at the federal level, not state rates, as each state has its own tax code. It is probably not a bad idea to reach out to a tax professional if you are in over your head.
How Are Investments Taxed? Capital Gains Explained
To better understand tax-loss harvesting, we first must understand capital gains and how they are taxed.
When you sell a stock, bond, fund, real estate, or other investment for a profit, you’ll need to pay capital gains tax to the IRS. If you hold the investment for under a year, the gain is subject to the short-term capital gains rate, which is determined by your ordinary income bracket.
2023 Federal Income Tax Brackets
| Tax Rate | For SingleFilers | For Married Individuals Filing Joint Returns | For Heads of Households |
|---|---|---|---|
| 10% | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 |
| 12% | $11,000 to $44,725 | $22,000 to $89,450 | $15,700 to $59,850 |
| 22% | $44,725 to $95,375 | $89,450 to $190,750 | $59,850 to $95,350 |
| 24% | $95,375 to $182,100 | $190,750 to $364,200 | $95,350 to $182,100 |
| 32% | $182,100 to $231,250 | $364,200 to $462,500 | $182,100 to $231,250 |
| 35% | $231,250 to $578,125 | $462,500 to $693,750 | $231,250 to $578,100 |
| 37% | $578,125 or more | $693,750 or more | $578,100 or more |
The IRS gives you a break on the tax rate if you hold the investment for over a year. In this circ*mstance, you will be subject to a long-term capital gains rate, which offers much lower rates than ordinary income rates.
2023Capital Gains Tax Brackets
| For Unmarried Individuals, Taxable Income Over | For Married Individuals Filing Joint Returns, Taxable Income Over | For Heads of Households, Taxable Income Over | |
|---|---|---|---|
| 0% | $0 | $0 | $0 |
| 15% | $44,625 | $89,250 | $59,750 |
| 20% | $492,300 | $553,850 | $523,050 |
Let’s say you buy a stock at $20, then sell it under a year for $35. The $15 gain is subject to the short-term capital gains tax rate. If you hold the stock for a year before selling it, you are subject to a long-term capital gains rate.
This is a straightforward example and most real-life scenarios will not be this direct. It usually takes a little bit more work to determine an investment’scost basis.
The cost basis is the true cost of an asset and is usually an adjusted amount, not just the price you paid when you purchased it. You will need to include commissions, dividends, and, in the case of real estate, improvements to the asset (renovations).
To find the basis when selling an individual stock or bond, list the purchase cost plus any commission you paid. Next, add in the value of any dividends received. This gives you an adjusted basis. Calculate the capital gain (or loss) by subtracting the sale proceeds from the basis.
If the investment is owned for one year or less, the gain is considered a short-term gain. These capital gains are taxed as ordinary income. Your ordinary income tax rate depends upon your income tax bracket.
If the investment is owned for longer than one year, the gain is a long-term gain. These capital gains enjoy lower tax rates, either 0%, 15%, or 20%.
How Does Tax-Loss Harvesting Work?
When you sell an investment for a loss, you realize an investment loss, whether it is a long-term or short-term capital loss. This capital loss is included on your tax return.
To “harvest” a loss is intentionally realizing a capital loss to offset any capital gains and minimize taxes.
For example, in January, you purchased $10,000 worth of the SPDR S&P 500 ETF (SPY). Then, the market falls, and your $10,000 SPY investment declines by -20% by December. Your investment is now worth only $8,000 (not including any dividends). If you sell SPY then, you will have a $2,000 loss.
Despite the pain of losing $2,000, tax-loss harvesting is the silver lining. You can use the $2,000 loss to reduce your taxes.
With tax-loss harvesting, you can use the capital loss to offset capital gains. If you don’t have any capital gains, you can use the $2,000 loss to offset up to $3,000 of ordinary income.
Tax Loss Harvesting Rules
Here are the specific rules to harvest capital losses:
- First, short-term losses must be used to offset short-term gains.
- You can use short-term losses to offset long-term gains if you don’t have any short-term gains.
- If you don’t have any short- or long-term gains, you can then use the short-term losses to offset up to $3,000 of ordinary income.
- If you have a loss greater than $3,000 remaining, it can be carried over into subsequent years and used to offset future capital gains and/or ordinary income. This is called the capital loss carryover, or capital loss carry forward rule.This is a crucial rule to always remember – you can sell an investment for a loss this year to use it to offset gains in future years.
- For long-term losses, the same sequence applies. Use long-term losses to offset long-term gains or short-term gains if you have no long-term gains. The remaining losses can be used to offset $3,000 of ordinary income.
Ultimately, net losses of either kind can be deducted against the other type of gain. Any remaining losses not used to offset capital gains can also be used. $3,000 can offset ordinary income with the remaining losses used to reduce taxes in future years. Although, if you use the married filing separate status, the net capital loss used to offset ordinary income is capped at $1,500.
The Wash Sale Rule – Investments
It is tempting to sell a security at a loss only to repurchase it right back. However, this is not allowed due to the Wash Sale Rule.
The IRS will not allow loss sellers to purchase the same or substantially identical security within 30 days before or after the sale, or the loss will be disallowed.
The Wash Sale Rule – Cryptocurrencies
It is important to note that the wash sale rule does NOT apply to cryptocurrencies (yet). Bitcoin and other crypto assets are considered assets and not investments. Therefore the wash sale rule can be safely ignored. Therefore, you could sell your entire crypto loss position (officially realizing that loss) only to buy it back immediately afterward.
Sell a Loss And Replace It
If you can’t purchase the same/identical security immediately after selling it for a loss, how do we get around the Wash Sale Rule? Simple – purchase asimilarsecurity.
For example, let’s say that you own shares in Coca-Cola Company (KO), which is currently at a loss for you. You decide to sell it, officially realizing a loss. Though you want to stick with your investment plan, so you need to find a similar alternative, such as Pepsi Company (PEP).
This can be accomplished through all different types of investments – stocks, bonds, funds, and even real estate.
Be careful, though – theIRS states explicitlythat the wash-sale rule prohibits selling an investment for a loss and replacing it with the same or a “substantially identical” investment 30 days before or after the sale.
This means that you cannot sell one S&P 500 ETF at a loss only to buy another S&P 500 ETF the next day (E.g., selling SPY and buying IVV).
Tax-Loss Harvesting Examples
Tax-Loss Harvesting Example 1
- Jenna has a gain of $30,000 on Fund A. She sells the Fund for a gain taxable gain of $30,000.
- She notices that Fund B is down $15,000 since she bought it.
- Instead of waiting for Fund B to rebound (or not), she decides to sell Fund B for a $15,000 loss.
- She harvested the $15,000 loss from the sale of Fund B to offset the $30,000 gain on the sale of Fund A.
- With tax-loss harvesting, her tax bill is $2,250, or 15% of the $15,000 gain.
- Without selling the losing Fund B, her tax on the $30,000 gain is $4,500.
- To keep her asset allocation constant, she bought a similar, although not identical fund, to replace Fund B.
- The net impact of tax-loss harvesting was to reduce the amount of federal income tax paid while keeping a constant asset allocation.
Tax-Loss Harvesting Example 2
- Justin has a gain of $30,000 from Fund A. He sells the Fund for a taxable gain of $30,000.
- He also lost $33,000 from the sale of Fund B.
- With no other capital gains than the $30,000, he can use the $33,000 loss from the sale of Fund B to offset the total $30,000 gain of Fund A and also to offset $3,000 of ordinary income.
- This further reduces Justin’s tax bill.
Tax-Loss Harvesting Example 3
- Mike has a long-term loss of $100,000 in Stock A.
- Mike decided to sell this year (2023), realizing the $100K loss.
- He has no gains to realize in 2023, so the loss carryforwards to 2023.
- Mike has a $100,000 gain in 2024. He realizes this gain.
- Because Mike has the $100K carryover loss from 2023, Mike is not liable for the $100K in gains in 2024 as the loss offsets this.
When DOESN’T Tax-Loss Harvesting Make Sense?
Yes. Tax-loss harvesting can be an excellent strategy for both your investment and tax planning. Though, it is not always the best approach.
Only sell an investment if there is a better alternative.Tax-loss harvesting shouldn’t take precedence over your investment philosophy. If you cannot find a similar security to replace it with, and/or you think the investment will rebound and appreciate in price relatively soon, then keep it.
Don’t sell if you are in a zero capital gain tax bracket.Let’s say that you are in-between jobs or you recently retired, and you are receiving no income for the year. This means that you are probably in the 0% income tax bracket. You might be better off selling gains at 0% rather than selling losses this year.
Your investment losses are in a tax-deferred or tax-free retirement account.Tax-loss harvesting doesn’t make sense if the loss is from an asset owned in a tax-advantaged retirement account. All assets owned within an IRA or retirement account aren’t taxed. (Except when you withdraw assets from a traditional IRA or 401(k) account.)
Is Tax-Loss Harvesting Worth it?
Yes, implementing a tax-loss harvesting strategy is absolutely worth it. If you need help from a financial professional, we are more than happy to assist.
As a financial expert deeply immersed in the intricacies of investment strategies and taxation, I can unequivocally attest to the significant advantages that tax-loss harvesting can offer to investors. My comprehensive understanding of the subject allows me to shed light on the nuances involved, making it an invaluable tool for optimizing portfolio returns.
Tax-loss harvesting, when executed correctly, holds the potential to elevate overall portfolio returns by strategically offsetting gains with losses. Despite its potential benefits, a surprising number of investors remain either unaware of this strategy or lack a sufficient understanding to implement it effectively. This guide aims to bridge that knowledge gap, providing a solid foundation for investors to grasp the basics of tax-loss harvesting and harness its advantages.
At its core, tax-loss harvesting involves selling an investment at a loss to counterbalance gains, either realized immediately or in the future. The key lies in the timing, requiring investors to execute the strategy before the year's end to capitalize on potential tax savings. It's crucial to note that tax-loss harvesting applies exclusively to taxable accounts, excluding retirement accounts like 401(k)s or IRAs.
Delving into the complex realm of taxes, particularly capital gains taxes, is essential to understanding tax-loss harvesting. Short-term capital gains, incurred on investments held for less than a year, are taxed at ordinary income rates, while long-term capital gains, stemming from investments held for over a year, enjoy significantly lower tax rates.
The concept of cost basis, representing the true cost of an asset, adds another layer of complexity. Calculating the adjusted basis, considering factors like commissions, dividends, and improvements in the case of real estate, is vital to determining the actual gain or loss on an investment.
Tax-loss harvesting works by intentionally realizing a capital loss through selling an investment at a loss, providing a silver lining amid market downturns. This capital loss can then be utilized to offset capital gains, effectively minimizing taxes. Importantly, if no capital gains are present, the losses can offset ordinary income, up to a limit of $3,000 per year.
Crucial rules govern tax-loss harvesting, dictating that short-term losses must offset short-term gains first. Long-term losses follow a similar sequence, with any remaining losses carrying over into subsequent years to offset future gains or income. The Wash Sale Rule prevents investors from repurchasing the same or substantially identical security within 30 days of selling it at a loss, ensuring the integrity of the strategy.
Intriguingly, tax-loss harvesting can be applied to cryptocurrencies, as they are considered assets rather than investments. The Wash Sale Rule does not currently apply to this emerging asset class.
Providing clarity through examples, tax-loss harvesting showcases its effectiveness in reducing tax liabilities while maintaining a consistent asset allocation. Whether offsetting gains from one investment with losses from another or carrying over losses to future years, the strategy proves its worth in diverse scenarios.
However, it's essential to acknowledge situations where tax-loss harvesting might not be the optimal choice. The strategy should not supersede fundamental investment principles, and investors should refrain from selling an investment solely for tax purposes if a better alternative is not available. Additionally, individuals in a zero capital gain tax bracket or those with losses in tax-advantaged retirement accounts may find tax-loss harvesting less advantageous.
In conclusion, tax-loss harvesting is a powerful and worthwhile strategy for investors, offering tangible benefits when employed judiciously. As a seasoned expert in the field, I encourage investors to explore and implement this strategy, potentially unlocking valuable tax savings and optimizing their overall investment approach.
