Key Points
- Tax-loss harvesting lets investors use losing investments to offset capital gains and reduce taxable income.
- The strategy only works in taxable accounts (not 401(k)s or IRAs).
- Understanding the wash-sale rule and timing trades correctly are crucial to avoid disqualified losses.
Tax-loss harvesting is the practice of selling investments that have dropped in value to realize a capital loss, then using that loss to offset capital gains from other investments or up to $3,000 of ordinary income per year.
The idea is simple: You’ve already lost money on paper. Selling that investment allows you to record the loss now and reduce your current tax bill. You can then reinvest the proceeds in a similar (but not identical) asset to stay invested.
It’s a legal, IRS-approved strategy – when used carefully.
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Simple Example
Imagine you bought 100 shares of Stock A for $5,000. Today those shares are worth $3,000, meaning you have a $2,000 unrealized loss.
You also sold Stock B earlier this year for a $2,000 gain.
If you sell Stock A, you can offset the $2,000 gain with your $2,000 loss—making your net capital gain $0.
If you have no other gains, you can deduct up to $3,000 in losses against ordinary income this year. Any leftover losses can roll forward to future years until they’re used up.
You can use The College Investor’s capital gains calculator to estimate your taxes if you don’t do this!
How To Harvest Tax Losses
Many robo-advisors include automatic tax-loss harvesting as part of their advisory services. But if you’re interested in implementing tax-loss harvesting on your own, the good news is that it’s a relatively simple process.
Step 1: Monitor Your Investment For Value Loss
Take the time to monitor your portfolio for investments that are losing value. When you notice a substantial drop in your investment’s value, it may be time to consider implementing a tax-loss harvesting strategy.
Step 2: Sell Investment At A Loss
When you find an investment that has lost value, you can sell it. At that point, you will realize a capital loss. Without the action of selling the investment, the capital loss remains unrealized and you miss out on the chance to harvest the tax losses.
For example, let’s say you invest $10,000 into a mutual fund. Six months later, the investment’s value has dropped to $8,000. If you miss the chance to sell your investment and it rebounds to $11,000, you won’t be able to use the temporary loss in value to reduce your tax liability.
Step 3: Repurchase A Similar Investment
Once you sell your original investment, it’s time to reinvest your funds. When you select a new investment, you’ll need to make sure that you are purchasing something similar but not identical.
The IRS will not allow you to pursue tax-loss harvesting if you purchase identical investments, otherwise known as a wash sale. A similar investment cannot be “substantially identical” to the original investment.
However, it’s possible to purchase different ETFs that target similar industries. Buying a similar investment will allow you to stick with your overall investment goals while taking advantage of short-term losses to minimize your tax drag.
Step 4: Claim The Loss
Once you’ve completed the mechanics of a tax-loss harvesting transaction, the next step is to claim the loss on your tax return. This final step will allow you to realize the tax loss in a meaningful way.
Depending on your capital gains tax bracket, you could save thousands with the help of this tax minimization strategy.
Limitations Of Tax-Loss Harvesting
Although tax-loss harvesting can be an exciting way to potentially save thousands, there are some limitations to be aware of. These limitations have been set by the IRS as a way to prevent abuse.
Wash Sale Rules
The wash sale rule prevents investors from attempting to harvest tax losses with identical investments. Under this rule, you cannot claim a capital loss on the sale of a security against a capital gain of the exact same security.
With that, you cannot buy and sell identical securities within 30 days before or after the sale to claim a capital loss. If you move forward with the buying and selling of identical securities within 30 days, the IRS will not allow you to claim a tax write-off.
Importantly, you can replace investments with similar mutual funds or ETFs. With similar mutual funds, your investment portfolio can be relatively similar without violating the wash sale rule.
Important Reminder: The wash sale rule doesn’t currently impact cryptocurrency. If you’re holding your crypto, you can “wash” your crypto to realize tax losses while still holding the same amount of tokens.
Only Benefits Taxable Accounts
Tax-loss harvesting is only possible in taxable investment accounts. Other investment accounts that are tax-deferred, like an IRA or 401(k), won’t benefit from tax-loss harvesting as are they aren’t subject to capital gains taxes.
Limits On Offsetting Ordinary Income
There is no limit to the amount of investment gains that can be offset with tax-loss harvesting. However, there are limits to the amount of taxes on ordinary income that can be offset.
As a married couple filing jointly or a single filer, you can realize up to $3,000 of capital losses to reduce your ordinary taxable income in a given year. If you’re a married couple filing separately, then you’ll only be allowed to claim up to $1,500 of capital losses in a given year.
Due to these limitations, there may be certain years that you have more capital gain losses than you can claim on your tax return. The good news is that you can carry these losses over to future tax years.
Additional Costs
If you’re aiming completing a tax-loss transaction each time one of your investments lose value, the strategy could become burdensome in multiple ways.
First, you may incur transaction costs if you don’t have a commission-free stock broker. And, second, frequent tax-loss harvesting could lead to higher tax prep costs when it comes time to file your return.
Before implementing tax-loss harvesting in your own portfolio, weigh the costs of completing the transaction and filing your taxes. You don’t want to go through the effort of harvesting a tax loss if the costs would outweigh the savings.
Final Thoughts
As you consider tax-loss harvesting, don’t prioritize this strategy over the value of a well-balanced portfolio. Although you can save on your tax bill through this strategy, it shouldn’t take precedence over building a portfolio that aligns with your investment goals.
If you’re starting out on your investment journey, take advantage of our free resources to help you build a portfolio that works for you. And if you’re looking for a “set it and forget it” tax-loss harvesting option, you may want to open an account with one of the top robo-advisors that can execute all the transactions automatically on your behalf.
Frequently Asked Questions
Can I use tax-loss harvesting for cryptocurrency?
Yes, crypto losses can be harvested—cryptocurrencies are considered property by the IRS, not securities. However, note that wash-sale rules don’t currently apply to crypto (though Congress has considered changing that).
Does this work for mutual funds and ETFs?
Yes, as long as they’re held in taxable accounts and the replacement fund isn’t substantially identical.
Can I harvest losses in my 401(k) or IRA?
No. Gains and losses inside tax-deferred or Roth accounts aren’t realized for tax purposes.
What if I have no gains this year?
You can still realize losses. They can offset up to $3,000 of ordinary income this year, and unused losses carry forward indefinitely.
How much can I save?
Savings depend on your tax bracket. For example, harvesting $5,000 in losses could save about $750 if you’re in the 15% capital gains bracket.
Do I need a financial advisor for this?
Not necessarily but a tax professional can help ensure trades are executed correctly and losses are reported properly.
Editor: Clint Proctor
The post Tax Loss Harvesting: A Step-By-Step Guide appeared first on The College Investor.
