Harvesting Tax Losses: A Strategy to Offset Gains and Manage Taxes

Tax-loss harvesting is a strategy that allows investors to offset capital gains by realizing investment losses, potentially reducing their overall tax liability. Understanding how this process works can help you manage your tax exposure and optimize your financial plan if you invest in stocks, bonds, or other assets.

Let’s explore how tax-loss harvesting works, when to use it, and common mistakes to avoid.

How tax-loss harvesting works

Tax-loss harvesting involves selling investments that have declined in value to offset taxable gains from other investments. This strategy can be advantageous if you have sold assets at a profit and expect to owe capital gains taxes. You can reduce your taxable income over time by strategically managing your portfolio.

• Capital gains and losses : When you sell an investment for more than you paid, you generate a capital gain. Conversely, selling for less than you paid results in a capital loss. The IRS allows investors to use capital losses to offset capital gains, potentially lowering their tax burden.
• Short-term vs. long-term gains : The IRS differentiates between short-term and long-term capital gains. Short-term gains (from assets held for a year or less) are taxed at ordinary income tax rates, while long-term gains (from assets held for more than a year) are taxed at lower rates. When harvesting tax losses, it’s important to match short-term losses with short-term gains and long-term losses with long-term gains to maximize tax benefits.
• The $3,000 deduction rule : If your total capital losses exceed your capital gains in a given year, you may deduct up to $3,000 of losses ($1,500 if married filing separately) from ordinary income. Losses exceeding this limit can be carried forward to future years.

When tax-loss harvesting makes sense

Using tax-loss harvesting wisely can help optimize tax efficiency, but it’s not always the best move. Here are some situations where it may be beneficial:

• If you have significant capital gains : Offsetting gains from highly appreciated investments with losses can help reduce taxable income.
• If you are in a high tax bracket : Tax-loss harvesting benefits individuals in higher tax brackets by offsetting capital gains, thereby reducing taxable income. It minimizes the impact of elevated capital gains tax rates, allowing investors to keep more earnings while managing their tax liabilities effectively.
• If you plan to reinvest strategically : Selling a declining investment only makes sense if you reinvest in a way that aligns with your long-term financial objectives.
• If the market is volatile : Market downturns can create opportunities for tax-loss harvesting without significantly altering your portfolio’s overall strategy. This strategy can enhance long-term tax efficiency.

Understand the wash-sale rule

The IRS enforces the wash-sale rule to prevent investors from selling an asset at a loss and immediately repurchasing the same or a substantially identical investment to claim a tax benefit.

• What the wash-sale rule prohibits : If you sell a security at a loss, you cannot buy the same or substantially identical security within 30 days before or after the sale. If you do, the loss is disallowed for tax purposes.
• How to avoid a wash sale : You can wait at least 31 days before repurchasing the same investment or purchase a similar (but not identical) investment to maintain portfolio balance. Many investors use exchange-traded funds (ETFs) or mutual funds as temporary replacements to avoid triggering the wash-sale rule while maintaining market exposure.
• Tax-loss harvesting for retirement accounts : This strategy does not apply to tax-advantaged accounts like traditional IRAs or Roth IRAs since investment gains and losses in these accounts do not generate immediate tax consequences.

Common pitfalls to avoid

While tax-loss harvesting can be beneficial, there are some pitfalls to be aware of:

• Selling solely for the tax benefit : Investors should avoid selling investments for tax reasons without considering their long-term potential.
• Triggering the wash-sale rule : Repurchasing the same investment too soon can disqualify a tax benefit.
• Neglecting transaction costs : Frequent trading can generate fees that outweigh potential tax savings.
• Ignoring the broader financial picture : Tax-loss harvesting should be integrated into a larger tax and investment strategy, considering factors like tax-efficient asset location, Roth conversions, and charitable giving strategies.

Final thoughts

Tax-loss harvesting can effectively manage taxes and enhance after-tax returns, but it should be applied strategically. Consider whether this approach aligns with your financial goals if you have investments with unrealized losses.
Since tax laws are complex and subject to change, consulting a tax professional or financial advisor can help ensure tax-loss harvesting is implemented effectively and complies with IRS regulations.