Nobody wants to pay more in taxes than they have to, so any time a tax-conscious investing strategy is available, it may be worth looking into.
Tax-loss harvesting is a popular strategy for leveraging your portfolio’s “losers” to offset the gains earned from its “winners.” Depending on your portfolio's makeup and other tax liabilities, certain years may be better suited for tax-loss harvesting than others.
To help you better understand when tax-loss harvesting could make the most sense, here’s a closer look at how it works, and what investors should consider before moving forward.
First, let’s talk about capital gains.
Before we dive into tax-loss harvesting, let’s briefly review capital gains and how they’re taxed.
- Capital gain = Profit you earn when selling an investment or asset.
Essentially, it’s the sale price of the investment or asset, minus the cost basis (what you paid for it).
- Capital loss = Losses you incur when selling an investment or asset.
If the sale price of the investment ends up below your cost basis (the amount you paid for the stock), you will experience a capital loss, as opposed to a capital gain.
The profit earned from selling an asset or investment is taxed in one of two ways, either as a short-term capital gain or a long-term capital gain:
- Short-term = You’ve held onto the investment for less than a year
Short-term capital gains are taxed at the same rate as your ordinary income, meaning the tax rate can be as high as 37%, depending on your tax bracket.
- Long-term = You’ve held onto the investment for more than a year
Long-term capital gains tax rates vary, though for 2024 they are either 0%, 15%, or 20% (depending on your taxable income level).1 For investors who fall in the 22% tax bracket or above, the long-term rate will be more favorable.
Tax-loss harvesting explained
The concept of tax-loss harvesting is fairly straightforward — however, the execution and caveats are, as with many investment strategies, a bit nuanced.
To complete a tax-loss harvesting strategy, you would sell poor-performing investments at a loss, and use that loss to either offset or eliminate the capital gains tax liability of other investments that sold for a profit. In other words, you’re using your capital losses to reduce the taxes owed on your capital gains.
When can you use a tax-loss harvesting strategy?
The whole premise of using a tax-loss harvesting strategy is to offset your taxable capital gains, right? For that reason, it really only applies to those investments held in your taxable brokerage accounts — or any other taxable investment profits, like the sale of a business, real estate, or other asset.
You wouldn’t use a tax-loss harvesting strategy on investments held in tax-advantaged accounts such as your 401(k), IRA, or Roth IRA because, well, there’s really no need to. Qualified distributions from your Roth accounts are tax-free anyway, and earnings in your 401(k) or traditional IRA grow tax-deferred until a withdrawal is made (likely in retirement).
If you do plan on “harvesting” losses to offset gains, you’ll need to do so before the calendar year ends on December 31. The IRS does not give investors a grace period. It’s also important to note that you may deduct up to $3,000 (or $1,500 for taxpayers who are married filing separately) in capital losses on a given year’s tax return.1 If you’ve incurred losses exceeding that amount, you can carry them forward into future tax years.
What if I didn’t experience any gains this year?
Even if you didn’t sell investments for a gain this year, you can still harvest capital losses and use them to offset your tax liability on ordinary non-investment income. Again, you’ll be subject to the IRS limit of $3,000 per tax year — and as mentioned above, you can carry any excess into future years until the entire loss has been claimed.
Who benefits from tax-loss harvesting this year?
You may want to consider a few factors when determining if this is the right time to implement a tax-loss harvesting strategy. Namely, market conditions and your total tax liability.
Market conditions: If you’re invested in certain assets, sectors, or niches that may have declined in value, and you believe they're unlikely to recover, it may make sense to remove them from your portfolio and reap the tax benefits.
Your total tax liability The purpose of tax-loss harvesting is to reduce your tax liability for the current tax year. If you’re already experiencing a lower-than-usual income year (say you recently entered retirement, you or your spouse took time off work, or you made a career switch), does it still make sense to try harvesting your losses? Generally speaking, the higher your tax bracket, the greater the impact your tax-loss strategy may have on your tax bill.
If you expect you’ll be in a higher tax bracket in the coming years, it may make more sense to hold off on harvesting losses until then — though everyone’s tax situation is unique.
Watch out for the wash-sale rule
Before proceeding with a tax-loss harvesting strategy, make sure you’re familiar with the wash-sale rule. If the IRS believes you’ve bought an identical investment (or one that is “substantially identical”) within 30 days of harvesting a loss, you may be found in violation of the wash-sale rule.2
Here’s the gist:
When you sell an investment and incur a capital loss, you can’t turn around and immediately replace it (or replace it with something too similar). Rather, the IRS requires you to wait at least 30 days following the sale of the initial security or asset before making such purchases. If the IRS catches you breaking the wash-sale rule and attempting to claim illegitimate losses on your taxes, you won’t receive the tax benefits of incurring capital losses. It will instead add the loss to the security’s cost basis for reporting purposes.
Tax-loss harvesting with ETFs
Exchange-traded funds (ETFs) are similar to stocks, in that investors can trade shares of them on an exchange at any time throughout the trading day. The difference, however, is that an ETF consists of a basket of securities (stocks, bonds, commodities, etc.). Traditionally, an ETF may be used to replicate the performance of a certain index, such as the S&P 500.
In terms of tax-loss harvesting, ETFs can aid investors in avoiding wash-sale rule violations, while still maintaining their desired exposure to certain sectors or asset classes. Say you’d like to harvest the losses of an underperforming tech stock, but you’d still like to maintain your current level of exposure to the tech sector. You could find an ETF that mirrors the NASDAQ-100 Technology Sector Index (NDXT) or another tech-focused ETF, for example.
Remember… keep your long-term goals a top priority
Just because you can take advantage of a tax-loss harvesting strategy doesn’t necessarily mean you should do so at every available opportunity. The markets will experience short-term fluctuations and volatility — that’s just a natural part of investing. If you’re following a long-term, buy-and-hold investing strategy, selling off today’s poor performers just for the tax break may not benefit you in the long run.
Simply put? Keep a long-term perspective on your portfolio and check in with your investing strategy before forging ahead with tax-loss harvesting.
Along the same lines, consider what you’ll do with the extra funds that won’t go to Uncle Sam. How can you best use your tax savings to support your long-term goals? Maybe it makes sense to purchase new ETFs or individual stocks that interest you, boost your tax-advantaged retirement accounts, or pad your emergency savings. Being intentional with your tax savings is just as important as deciding whether to pursue a tax-loss harvesting strategy in the first place.
Is this year the right time for you to pursue a tax-loss harvesting strategy? The answer is, it depends! Your portfolio, exposure to recent market volatility, and tax situation are unique, and those factors will likely determine whether harvesting capital losses makes sense this year.
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