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.
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.
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.
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.
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.
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.
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.
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.
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:
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.
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.
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.
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:
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.
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.
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.
You’ll need a trading account to sell (and buy) stock. Explore your options by comparing features, fees and investor feedback to find the best brokerage account of 2024 that meets your needs.
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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.
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