Tax loss harvesting is defined by Investopedia as “the selling of securities at a loss to offset a capital gains tax liability.” This is a common technique investors use to eke some benefit from a loss on a security that is held in a taxable account.
As simplistic as it may sound, a loss on a security — such as an individual stock, bond, mutual fund or exchange-traded fund (ETF) — means that its market value is lower than what you paid for it. Losses on securities can be deducted for tax purposes if realized in a taxable account. Securities held in a tax-deferred retirement account like an IRA or a 401(k) are not subject to taxes on any gains or losses resulting from their sale.
How tax loss harvesting works
If shares of a security are held for less than one year, any gains or losses are considered short-term for tax purposes. This means that short-term gains would be taxed at the same rate as any other regular income that you earn from salary, self-employment or other sources. If the shares are held for more than one year prior to the sale, any gains would be taxed at the long-term capital gains rate, which might be lower than your tax rate on other income.
The concept of tax loss harvesting is that the losses realized on the sale of securities during the year can be used to offset gains that are realized on the sale of other securities or other income.
Let’s say you purchased 100 shares of XYZ company stock at a cost of $20 per share. The cost of these shares is $2,000. The shares fall to $10 per share, making the total value of the shares $1,000. If you sold the shares, you would realize a loss of $1,000.
Let’s also say that you sold 200 shares of ABC company during the year at a total gain of $2,500. This gain normally would be taxed at the appropriate rate.
Using tax loss harvesting, you could net the loss of $1,000 from the sale of the XYZ shares against the $2,500 gain from the ABC shares to reduce your overall capital gains for the year to $1,500.
These are the basics;however, it’s not quite so simple in practice. It’s important to note that the examples above and throughout this article will ignore both state income taxes and the transaction costs to buy and sell the securities. Each state handles capital gains and losses differently, so the impact will vary. Transaction costs to buy a security are added to the cost basis, while transaction costs to sell serve to reduce the amount realized, and that is subject to a gain or loss.
Long-term vs. short-term gains/losses and the leftovers
The rules for offsetting gains and losses specify that gains and losses of the same type should first be used to offset each other. You’ll need to look at any gains and losses realized during the year and match short-term gains with short-term losses and do the same with long-term gains and losses.
If the losses of one type exceed the gains of that same type, the excess losses then can be applied to other capital gains.
For example, if you had $3,000 in short-term capital losses for the year but only $2,000 in short-term capital gains for the year, then the excess $1,000 in short-term losses could be applied against any long-term capital gains for the year.
Note that capital gains distributions from mutual funds or ETFs also can be offset by capital losses realized elsewhere.
To the extent that you have excess capital losses that can’t be applied against capital gains for the year, the IRS says you can deduct up to $3,000 of these losses ($1,500 if married filing separately) against other taxable income. Any excess losses above that amount can be carried forward into subsequent years.
Katie Brewer, a fee-only certified financial planner and president of her Dallas-area firm Your Richest Life, deals with this issue in virtually serving many of her (primarily) Generation X and Generation Y clients. She indicated that a number of her clients have concentrated positions in employer stock that they try to diversify by selling a portion of each year. Brewer looks for losses elsewhere in their taxable holdings, or for specific shares of the employer stock that may have declined in value, to offset some or all of the gains from the sale of the employer shares to minimize the tax hit.
What is the wash-sale rule?
The IRS defines a wash sale as occurring when a security is sold at a loss and then the same or a substantially identical security is purchased within a 30-day window before or after the sale.
As you might imagine, this can get complex rather quickly. If you sold shares of IBM stock and realized a loss, that’s pretty straightforward.
On the other hand, if you sold Vanguard’s S&P 500 mutual fund at a loss and then turned around and purchased Fidelity’s S&P 500 mutual fund within the specified the time frame, that could well be considered a violation of the “substantially identical” rule. However, if you instead purchased a mutual fund that invested in the total stock market (and a different benchmark index from the S&P 500), you likely wouldn’t be in violation.
There is one other area for caution using the IBM example. If you sold your shares in a taxable account to realize a loss and then turned around and purchased IBM shares in an IRA account (as an example), you would be considered in violation of this rule if the purchase was within the specified time frame.
If you are found to be in violation of the wash-sale rule, you will not be allowed to use the tax loss when you file your tax returns.
Manual vs. automated harvesting
What we described above typically is done manually by investors and often occurs around the end of the year. There are also a number of robo-advisors that advertise tax loss harvesting as a service they offer to clients.
For example, Betterment offers automated tax loss harvesting and touts its Tax Loss Harvesting+ strategy as one that looks for opportunities to harvest losses on a regular basis and does a better job of reducing tax exposure than other automated models. It indicates that its service includes:
- An automated algorithm
- No extra trading costs associated with these transactions
- Reinvestment of every dollar that is harvested
- No short-term capital gains
- IRA harvest protection against the “substantially identical” rule mentioned earlier
- Customer protection for realized losses
Wealthfront, another major robo-advisor, offers a similar service. Schwab Intelligent Portfolios cites tax loss harvesting as an offered service, as does SigFig for users of its managed account option. Personal Capital appears to offer some form of tax loss harvesting for investors with at least $200,000 in investable assets.
Tax loss harvesting can be a great service, but it’s important to understand how a robo-advisor does this, including how it decides where to invest the money from the tax loss sales.
Tax loss harvesting is a potentially valuable tool that investors should be aware of. While nobody likes to lose money on investments, losses do happen. If those losses occur in a taxable (nonretirement) account, harvesting tax losses can help minimize your tax hit on gains elsewhere.
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