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What is tax-loss harvesting?

Tax-loss harvesting can help you use investment losses to cut your tax bill, but should you do it?

Tax-loss harvesting is an investment and tax-reduction strategy that can help reduce your tax bill at the end of the year. But tax-loss harvesting can be complicated, and its potential tax benefits may not outweigh the downsides.

What is tax-loss harvesting?

Tax-loss harvesting is the deliberate selling of securities at a loss to offset capital gains, and it can also help you lower your taxable income by as much as $3,000 each year.

How does tax-loss harvesting work?

Tax-loss harvesting works by using the losses on your investments to offset capital gains. Long-term capital losses are first used to offset long-term gains, while short-term losses are first deducted against short-term gains. After that, excess losses can be used to offset the other kind of gain. If there are no gains, you can use excess losses to reduce regular income.

IRS rules allow individuals to claim up to $3,000 ($1,500 if married filing separately) in deductible capital losses each year. You can carry any loss over this limit forward to later years too.

Example

Say you sell an investment you purchased for $1,000 for $3,000, giving you a realized capital gain of $2,000. This $2,000 gain is taxable in the year you sold the stock and took the profit. Now say you have another stock you bought for $5,000 that is now worth $2,000.

You can deliberately sell that losing investment, harvest the loss to offset that $2,000 gain and apply the excess $1,000 to reduce your taxable income when taxes are due.

6 tax-loss harvesting rules and considerations

  1. You can claim up to $3,000 in annual tax breaks if your capital losses exceed your capital gains.
  2. This strategy is only useful for taxable accounts — the IRS does not tax growth on investment earnings in retirement accounts.
  3. You have up until December 31 to wrap up the tax-loss selling process.
  4. You can carry losses above the $3,000 limit into future years.
  5. The wash-sale rule prohibits an investor from claiming a loss on the sale of an investment and then buying a “substantially identical” security within 30 days before or after the sale. So you need to be strategic with how you redeploy those funds.
  6. While anyone can harvest losses, the strategy is most impactful for those in high tax brackets. The higher your tax bracket, the higher your tax rate. And the more impactful tax-loss harvesting becomes.

Advantages and disadvantages of tax-loss harvesting

Tax-loss harvesting allows individuals to reduce taxes owed by offsetting realized capital gains with realized capital losses. Even if you don’t have capital gains, you can still use the losses to reduce your regular taxable income.

But offloading all your losing investments for tax purposes may not benefit your investment portfolio — at least not in the long run. Investing is a long-term game, and unless there is something fundamentally wrong with the asset, holding an investment you believe in may be more valuable than the tax deduction you can get today.

What’s more, tossing out securities that have experienced a drop in value could throw off your portfolio’s overall asset allocation and diversification. And with the wash-sale rule in place, you need to be careful with how you reinvest proceeds.

Wash-sale rule

The IRS designed the wash-sale rule to prevent investors from abusing tax-loss harvesting to reduce their tax liability. The rule stipulates that you can’t claim a loss on an investment if you purchase the same or a “substantially identical” security within 30 days before or after the sale.

One common way to avoid the wash-sale rule if you sell an individual stock that has incurred losses is to replace it with an exchange-traded fund (ETF) or mutual fund that provides exposure to the same industry or asset class. The extent of the overlap of the new security with the original investment is what the IRS looks at when determining if the wash-sale rule applies.

Even well-meaning investors unintentionally break the wash-sale rule, though. That said, breaking it won’t result in a fine or penalty — it only means you can’t recognize the loss for tax purposes.

Like tax-loss harvesting, the wash-sale rule can be tricky to navigate, which is why tax-loss harvesting is often best left to the experts.

Is tax-loss harvesting worth it?

Tax-loss harvesting can be an effective strategy, as it lets you reduce taxes owed at the end of the year. These tax savings can be significant, especially in a high tax bracket. And if you’re already rebalancing your portfolio because your investment strategy has changed, it could be a great time to employ tax-loss harvesting for the securities you sell.

But the strategy may not always make sense. Depending on your income and tax bracket, tax-loss harvesting may not be worthwhile.

For example, if you make less than $41,675 annually — or $83,350 if married filing jointly — harvesting long-term losses may not be worth it since there’s no tax due on long-term capital gains if your taxable income is less than or equal to $41,675. If you’re in a zero tax bracket, selling capital gains may actually be the better choice.

Should you attempt tax-loss harvesting on your own?

Tax-loss harvesting is more complex than simply selling losers to offset taxable gains from winners. It’s a strategy that may not be suitable for beginners. Even experienced investors can get it wrong.

Finder asked over 20 investment experts whether investors should attempt to perform tax-loss harvesting on their own. The almost-unanimous answer was:

  • No: because understanding the strategy’s value isn’t the same as effectively executing it.

One nuance is understanding the distinction between short-term and long-term capital gains when determining how to deduct capital losses, as one can be more valuable depending on your personal tax situation.

  • Short-term capital gains are gains from investments bought and sold over one year or less. These gains are taxed at your regular income tax rate. Harvesting losses to offset short-term gains may be more valuable since short-term gains are taxed at a higher rate.
  • Long-term capital gains apply to investments held for over one year. And the tax brackets for these gains sit at 0%, 15% or 20%, depending on your annual income.

Choosing which losses to claim while maintaining portfolio diversification and avoiding trouble with the wash-sale rule is a delicate balancing act. And beginners are likely best off relying on a financial professional or service that can perform tax-loss harvesting for them.

3 robo-advisors that offer tax-loss harvesting

Tax-loss harvesting is best performed by a financial professional. That said, an increasing number of automated services like robo-advisors are offering customers a tax-loss harvesting feature as part of their auto-rebalancing calculations. The following robo-advisors each offer their own version of automated tax-loss harvesting:

1. Betterment

Sleek, clean and easy to navigate, Betterment offers low-pressure, set-it-and-forget-it investing for an annual fee of 0.25% of your investing account balance.

2. Wealthfront

A highly rated mobile app and certified financial planners are among Wealthfront’s best perks — but a $500 minimum deposit is required. Wealthfront charges an annual fee of 0.25% to access its automated investing account.

3. Schwab Intelligent Portfolios

You need a portfolio with investments of at least $50,000 to tap into the tax-loss harvesting feature that comes with Schwab Intelligent Portfolios, but the service is free to use, and it has live customer support available 24/7.

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Bottom line

Tax-loss harvesting is a strategy that can help lower capital gains tax and reduce taxable income, but its many moving parts are likely unsuitable for beginners. Before implementing this loss harvesting strategy on your own, consider consulting a tax professional for financial advice specific to your tax situation and financial goals.

If you’re keen to take advantage of this strategy, explore your robo-advisor account options. These investment services can automate the process to ensure you get the most out of your portfolio.

Frequently asked questions about tax-loss harvesting

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