Tax-loss harvesting can be an effective investment strategy — if you know what you’re doing. But this tax-mitigating maneuver can be complicated, and tax benefits are limited to $3,000 annually.
Tax-loss harvesting — also known as tax-loss selling — is an investment strategy that can help reduce your taxes owed at the end of the year. And in practice, it’s just what it sounds like: a method of harvesting down investments to deduct the loss from your capital gains.
Think of it this way: you owe capital gains tax on any investments you sell for a profit, right? But not all of your investments perform well — in fact, some of them will lose money. Now, what if you strategically sold those down investments at a loss and claimed the loss against your capital gains? That’s tax-loss harvesting.
Three caveats to bear in mind:
- You can only claim up to $3,000 in tax breaks per year against your capital gains.
- This strategy is only useful for taxable accounts — retirement accounts are already tax-deferred.
- You only have up until the end of the calendar year — December 31st — to wrap up the tax-loss selling process.
Tax-loss harvesting in action
We’ve covered how tax-loss harvesting works in theory, but what does it look like in practice?
Well, suppose you invest $5,000 in a mutual fund. One year later, the value of your investment drops to $4,000 — ouch. That’s a $1,000 loss. If your investments are taxed at a long-term capital gains tax rate of 15%, selling this mutual fund at a loss generates $150 in tax savings.
Tax-loss harvesting can be an effective way to minimize capital gains taxes and can be performed by:
- Investment advisers.
- You — if you’re up for it.
On the surface, tax-loss selling seems straightforward: find down investments, sell them and lower your capital gains. But it’s a little more complicated than that. Before you attempt tax-loss harvesting, you need to consider your portfolio’s diversification and the wash-sale rule.
1. Portfolio diversification
Offloading all of your down investments may not be beneficial for your portfolio — at least not in the long run. In some instances, you may want to wait for your investments to recover.
Tossing out anything that’s experienced a dip could throw off the diversification of your portfolio. And a portfolio that lacks diversification is typically exposed to more risk than investments that are well-diversified.
2. The wash-sale rule
The wash-sale rule stipulates that you can’t claim a loss if the same or substantially similar security is purchased within 30 days of the loss. And this 30-day window applies to before and after the loss-realizing sale.
The wash-sale rule was designed by the IRS to prevent investors from abusing tax-loss harvesting. Even well-meaning investors unintentionally break the wash-sale rule.
For example, let’s say you buy a stock, notice that it’s plummeting and sell it at a loss two weeks after purchase. Or say you sell a fund at a loss, then repurchase a similar fund a week later. In both of these instances, you’ve violated the wash-sale rule.
Running afoul of the wash-sale rule isn’t the end of the world — you won’t be met with a fine or penalty — it only means you can’t recognize the loss for tax purposes.
But the bottom line is that the wash-sale rule can be tricky to navigate, which is why tax-loss harvesting is often best left to the experts.
Tax-loss harvesting can be an effective investment strategy — but it’s not for everyone. And that’s because depending on your income and tax bracket, it may simply not be worth your while. To determine whether or not tax-loss selling will have an impact on your portfolio, understand how short- and long-term capital gains work.
- Short-term capital gains are gains from investments bought and sold over the course of one year or less. These gains are taxed at your regular income tax rate.
- Long-term gains kick in after you’ve held the investment for over one year. And the tax brackets for these gains sit at 0%, 15% or 20%, depending on your annual income.
Tax-loss harvesting is at its most impactful for those in higher tax brackets. If you make less than $40,000 annually — or $80,000 if filing with a spouse — it may not make much of a difference.
|0%||$0 – $40,000||$0 – $80,000|
|15%||$40,001 – $441,450||$80,001 – $496,600|
Brandon Renfro, certified financial planner and assistant professor of finance at East Texas Baptist University, tells Finder, “When your portfolio is larger, tax-loss harvesting becomes more important in terms of relative impact. Gains on larger portfolios are likely to create a higher tax liability for you — not only because of their size, but because that size may push you into a higher tax bracket.”
The higher your tax bracket, the higher your tax rate. And the more impactful tax-loss harvesting becomes.
Should you attempt tax-loss harvesting on your own?
Not unless you really know what you’re doing. This strategy isn’t suitable for beginners and even experienced traders can get it wrong.
We 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 value of the strategy isn’t the same as effectively executing it.
Mary Lago, certified financial planner, certified trust and financial advisor and executive vice president of Ferguson Wellman Management explains, “Tax-loss harvesting is nuanced and requires active monitoring of timelines if you want to switch back into the original positions as quickly as possible.”
Maintaining portfolio diversification while avoiding trouble with the wash-sale rule is a delicate balancing act. And those new to the market are likely best off relying on a service that can perform tax-loss harvesting for them.
Tax-loss harvesting is best performed by automated services like robo-advisors. Not all robo-advisors offer this service, but some do, including:
- Betterment: 0.25%-0.40% service fee
Sleek, clean and easy to navigate, Betterment offers low-pressure set-it-and-forget-it investing with fees that start at 0.25% of your account balance.
- Wealthfront: 0.25% service fee
A highly rated mobile app and certified financial planners are among Wealthfront’s perks — but a $500 minimum deposit is required.
- Schwab Intelligent Portfolios: Free
You need a portfolio of at least $50,000 to tap into Schwab’s tax-loss harvesting feature, but the service is free to use and its customer support is available round-the-clock.
You’ll need a trading account to sell (and buy) stock. Explore your options by comparing features, fees and investor feedback to find the brokerage account that best meets your needs.
*Signup bonus information updated weekly.
Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.
Tax-loss harvesting can help offset capital gains, but with its many moving parts, it’s simply not suitable for beginners.
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’re getting the most out of your portfolio.