Tax loss harvesting – what it is, how it works, and how to apply it to your portfolio to maximize your savings
Disclaimer: The information provided is not intended as tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. Individuals are encouraged to seek specific advice from their personal tax or legal counsel.
Nobody likes to lose money on their investments, and it can be especially defeating to take a loss on something you were confident in. That said, no amount of research, due diligence, or time spent pouring over the details of an investment will ever prevent us from taking a hit sometimes. But that’s okay!
Although we’d love to be able to avoid losing investments altogether, we can’t. Fortunately, there are some ways to use those losses to your advantage come tax season.
An overview of investment taxes
Taxes are complicated, and the IRS treats almost every kind of income differently. Income from investments aren’t exempt from this reality, and they too get their own unique set of rules come tax time.
Capital gains: Profits made on investments are treated as capital gains—or, in other words, money that was made as a result of owning capital. In this case, an “investment” refers to something like stocks, bonds, ETFs, etc. Capital gains also apply to profits that come from things like real estate, collectibles, and more. And they get taxed in two different classifications.
Short-term capital gains: Short-term capital gains are profits made on the sale of an asset (capital) that you held for less than one year. Income received from short-term capital gains is taxed as ordinary income—or basically, in whatever tax bracket you fall in that year.
Long-term capital gains: In 2018, the Tax Cuts and Jobs Act changed the way long-term gains were taxed, allotting these profits their own unique tax brackets. As of the time this blog is written, long-term gains currently have 3 tax brackets ranging from 0%, and as high as 20% for higher earners. As we can see, longer-term gains are treated better come tax time—a savings reward for investors who hold over the long run.
Capital losses: On the other hand, capital losses are treated exactly like that—as a loss. Investors can deduct up to a certain amount in capital losses per year from their ordinary income and other capital gains in order to offset income.
What is tax loss harvesting?
Now that we’ve established the basics, let’s dive into how exactly we can use capital losses to our advantage come tax time—enter tax loss harvesting.
On the most basic level, tax loss harvesting (or TLH) is simply the act of using your losses to offset your gains, and subsequently your tax liability. It’s a tax hack that’s been around for ages and will likely continue to be loved for years to come. Sure, everyone would much rather have turned a profit than have a loss on the books, but being able to use the loss to save a little money is a nice consolation prize. #amirite
You can do this at any time during the year, but it’s most often a year-end strategy that investors implement while assessing their portfolio’s overall performance.
We commonly see people practice tax loss harvesting when selling off losing assets to offset the gains they’ve accrued in others. But, you can apply that same practice to offset some ordinary income, too. Oftentimes, investors will also replace the losing assets they sold off with a similar one in order to maintain an analogous portfolio composition.
But beware of the wash sale rule if you go this route. The rule states that an investor cannot purchase back a security that is “substantially identical” to the one they just sold. This is a little ambiguous as it’s not just limited to buying back the exact same asset, but there are plenty of ways to avoid it.
Downsides of tax loss harvesting
Tax loss harvesting sounds like it’s an easy, all-positive event from the surface, right? But looking a little closer will reveal some things to watch out for.
Only certain accounts apply
TLH locks in guaranteed losses, and you’re essentially trading that for tax savings. Additionally, it’s also not a viable strategy for tax-deferred account types like a 401(k) or IRA.
In years of a rough stock market, many portfolios are hanging onto thousands in losses. It’s important not to sell abruptly in a crisis, though, and to carefully consider if locking in those losses is worth the tax savings—or if you’d be better-suited holding for the long run and (hopefully) making the loss back when the markets (eventually) recover.
Situational times cause for situational measures
Not all investments come in the same package, and not all investments should be sold at a loss for harvesting. If you’re planning to hold something for the long run, don’t let temporary drops spook or sway you.
Ultimately, you just need to budgeted for taxes—just like anything else.
How to apply tax loss harvesting to your portfolio
Let’s start with an example. Investor X sold an ETF that was held for 11 months for a profit of $10,000. With an income of $100,000 (we're over simplifying and assuming no other factors will impact their tax situation), they would owe $2,957 in taxes on those short-term gains.
However, investor X also held a stock for 11 months that has a net loss of $5,000. If they were to sell this holding, this calculator shows how they could reduce their taxable capital gains to $7,000, and subsequently their tax obligation to $2,065, for a total savings of $892.
There are a variety of unique scenarios you might find yourself in where tax loss harvesting can afford you similar, or even greater, savings on your tax bill. Ultimately, you’ll need to complete a portfolio analysis to see which actions make sense for your situation.
Tax loss harvesting with discretion
To distill it down, tax loss harvesting is a money-saving tactic we use to compensate for the inevitable losses we’ll endure while investing. It’s not for everyone, and it’s not for every situation, but it certainly can be a valuable tool to add to your belt to utilize when the time is right.
Simply by reading this detailed post about taxes, you’re already a savvy investor, why not add even more to your repertoire by logging into the app once a week and completing your to-do list?