Some investors may be looking for ways to manage their potential investment-related losses and tax obligations. If this describes you, tax-loss harvesting might be a strategy worth considering. However, it can be difficult to execute and should not be attempted without first consulting a tax professional as the amount of savings provided by tax-loss harvesting may depend on your tax bracket and investment allocation, among other considerations.
To help you understand tax-loss harvesting, here’s a basic primer about what it is and how it works.
What is Tax-Loss Harvesting?
Tax-loss harvesting is a process that involves deliberately selling securities at a loss in order to offset your earnings from other securities, thereby potentially reducing your tax burden. In other words, if you have an investment that’s lost value, you can sell it and deduct the value of that loss from the gains you realize elsewhere. That deduction lowers your total taxable income for the year, which may result in tax
savings.
This IRS-approved tax maneuver is only applied to investments bought and sold within taxable accounts; losses cannot be deducted from tax-deferred accounts like traditional IRAs and 401(k)s. Even if your investments only lose money and you don’t realize any capital gains in a particular year, you can still use investment losses to help offset your ordinary income for that year.
Be sure to check the annual limits on the amount of capital gains losses you can deduct from your income each year, although losses that exceed the annual limit can be carried over into following years for harvesting purposes.
What Might Tax-Loss Harvesting Look Like?
To illustrate what tax-loss harvesting can look like in practice, let’s say you bought a stock less than a year ago that’s since gained $10,000 of value. In most cases, long-term losses (incurred by assets you’ve held for more than a year) can only be used to offset long-term gains. Short-term losses (incurred by assets you’ve held for less than a year) can only be used to offset short-term gains. Also less than a year ago, you bought a stock that ended up losing $15,000 of value over the same period. You sell the first stock at a profit of $10,000 and the second stock at a loss of $15,000 for a net loss of $5,000.
In this case, your $15,000 loss would offset all of the taxes you owe on the $10,000 profit, and you can use the additional $5,000 to offset up to $3,000 of your ordinary income (the IRS limit). The remaining $2,000 loss can then roll over into the following tax year.
Bear in mind that these deductions are taken from your total income that’s subject to taxes, not from your tax bill. Assuming a 24% tax rate and that your deduction doesn’t drop you into a lower tax bracket, harvesting a loss of $3,000 might save you $720 in ordinary income taxes. The savings have the potential to be even greater as your tax rate increases.
Tax-loss harvesting can be a complicated tactic with many moving parts; it may require you to consult with a financial professional beforehand and it won’t be an effective strategy for every investor in all situations.
Key Considerations for Tax-Loss Harvesting
While you can sell an investment and lock in a loss at any time of the year, many choose to wait until year-end to tax-loss harvest so they can gain a full picture of their annual portfolio performance and its tax implications. The deadline for tax-loss harvesting each year is December 31.
After tax-loss harvesting, consider replacing the assets you’ve sold with others that complement your financial goals and the other investments in your portfolio. Those replacements must meet certain requirements, though. As part of the wash-sale rule, the IRS imposes a 30-day waiting period from the time of sale before you’re able to purchase a “substantially identical” asset to the one you sold.1 Failure to meet these requirements may preclude you from claiming your investment losses for tax purposes.
Tax-loss harvesting operates on the basic idea that a dollar is worth more today than it will be in the future since that dollar can be invested and has the potential to grow before your tax bill comes due. While effective tax-loss harvesting can bear fruit over time – or at least help mitigate losses – it’s still a risky strategy that requires careful planning.
In many cases, it may not be worth it to sell an asset simply to earn the associated tax deduction. More likely, your decision to sell depreciated assets (and harvest the losses from them) will be part of a broader portfolio adjustment or reallocation strategy.
Could Tax-Loss Harvesting Make Sense for You?
By leveraging tax-loss harvesting as another tool within your financial toolbox, you may be able to lower your total tax burden and make tax-efficient adjustments to your investment strategy over time. However, it’s not a tool that should be used lightly – the process can be complex and may not result in savings if improperly handled.
If you’d like to learn more about tax-loss harvesting or other tax-efficient tactics, reach out to a financial professional to discuss your options. A financial advisor can help you determine whether this tactic could help you meet your investment goals.
Best,
Robert (Rory) J. O’Hara III, CFP®, CRPC®
Founder I Senior Managing Partner
This material is intended for informational/educational purposes only and should not be construed as tax, legal or investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Certain sections of this material may contain forward-looking statements. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is no guarantee of future results. Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption of any kind. Please consult with your financial professional and/or a legal or tax professional regarding your specific situation and before making any investing decisions.
Endnotes
1 “Publication 550 (2021), Investment Income and Expenses.” Internal Revenue Service. Accessed February 10, 2023.
https://www.irs.gov/publications/p550#en_US_2021_publink100010601
