What is Tax-Loss Harvesting? - MagnifyMoney

Tax-Loss Harvesting: Everything You Need to Know

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Tax-loss harvesting can help investors maintain a tax-efficient portfolio by using capital losses to offset capital gains. This strategy is designed to take some of the sting out of selling securities — whether it be stocks, mutual funds, exchange-traded funds (ETFs) or other investments — for less than what you paid for them.

While it won’t work with tax-advantaged accounts, such as a 401(k) or IRA, losses can be harvested for securities held in a taxable investment account. In this article, we cover how exactly tax-loss-harvesting works and what rules and limitations you should be aware of.

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What is tax-loss harvesting?

Tax-loss harvesting allows an investor to sell losing investments to offset capital gains and prevent paying taxes on those gains.

A capital gain is the profit you receive from selling an investment for more than what you paid for it. A capital loss is the opposite; you realize capital losses when selling investments for a lower price than for what you purchased them.

Capital gains are taxable, while capital losses can be tax-deductible. Both capital gains and capital losses can be categorized as short- or long-term, depending on how long you held the investment before the sale. Typically, if you hold a security for a year or less before you sell it, your capital gain or loss is short-term.

How does tax-loss harvesting work?

Tax-loss harvesting balances capital losses against capital gains. Implementing a tax-loss harvesting strategy means understanding:

  • Which type of investment accounts you own
  • Which of your investments resulted in a capital loss
  • Which investments yielded a capital gain

The mechanics of tax-loss harvesting are relatively simple. First, review performance for each security you own in a taxable account. Once you identify the winners and losers, you can then decide which ones you want to sell. Tax losses are harvested as you sell investments for a capital loss or gain.

Tax-loss harvesting example

Here’s a more detailed example of how to tax loss harvest inside a taxable account: Let’s say you purchased 100 shares of XYZ company’s stock at $20 per share for a total investment of $2,000. Those shares then drop in value to $10 per share, reducing their collective value to $1,000. If you sell them at that price, you’d realize a capital loss of $1,000.

Now assume that you purchased 100 shares of a different company, at $20 per share. Those shares increase in value to $30 each, resulting in a $1,000 capital gain on your investment when it’s time to sell. Using tax-loss harvesting, you could use the $1,000 capital loss from Investment A to cancel out the $1,000 capital gain from Investment B.

Is tax-loss harvesting worth it?

Tax-loss harvesting can yield tax benefits if you’re focused on minimizing capital gains tax liability. For example, research from robo-advisor Wealthfront found that new clients who used their tax-loss harvesting service in 2018 would have easily received pre-tax benefits that exceeded the market’s declines for that year. This tax strategy can also help reduce the taxes incurred from day trading.

There are, however, some potential downsides. First, harvesting losses may be less effective for investors with fewer investable assets. A Vanguard study found that tax-loss harvesting benefits can range from zero tax benefit to a negative return to gains of more than 1% annually. But according to the research, those most likely to benefit were in the top 2% of net worth distribution.

Offsetting capital gains should also be balanced against the costs involved. If you’re paying commissions to a brokerage each time you buy or sell investments to harvest losses, that could add up to more money than you’d save in taxes.

Tax-loss harvesting rules and limitations

Wash sale rule

According to the IRS, a wash sale is “a sale of stock or securities at a loss within 30 days before or after you buy or acquire in a fully taxable trade, or acquire a contract or option to buy, substantially identical stock or securities.”

A simpler way to define a wash sale is buying securities that are very similar to ones you sold for tax-loss harvesting purposes within a 30-day window. That window applies to the 30 days before and after a trade occurs.

The key reason to avoid a wash sale is because the IRS doesn’t allow you to reap the benefits of tax-loss harvesting on those transactions. Essentially, this rule is designed to prevent investors from getting a tax deduction on capital losses for which they immediately buy back an identical or nearly identical investment. Here are some examples of when the wash sale rule does and doesn’t apply:

  • It is a wash sale if… you sell shares of a company and repurchase shares of that same company within 30 days.
  • It’s not a wash sale if… you buy shares of common stock and shares of preferred stock in the same company.
  • It’s not a wash sale if… you sell shares of a financial services company and buy shares in a mutual fund or ETF that holds financial services companies.
  • It’s not a wash sale if… you sell shares of a tech company, then buy shares in a different tech company.

Tax-loss harvesting limit

Tax-loss harvesting can offer tax benefits, but there are limitations on what you can deduct. Currently, the amount of excess losses you can claim as a deduction is the lesser of $3,000 ($1,500 if you’re married and file separately) or the total net loss that appears on line 21 of Schedule D on your tax return.

The good news is that, if your total losses exceed the deduction limit, you can carry the difference over to future tax years.

Where to turn get help with tax-loss harvesting

Tax-loss harvesting is something you can do on your own. It can be complicated, though, and there are several items to keep in mind — most significantly the wash sale rule and deduction limits. If you need help with tax-loss harvesting, you have some options.

A financial advisor

Financial advisors can offer tax-loss harvesting to clients. Whether this is done automatically or at the request of individual investors can vary, depending on the firm’s policy and advisory strategy.

If a financial advisor is harvesting losses for you, they may complete a thorough review of your portfolio to assess how well or poorly each of your investments has performed. The advantage of using a human advisor to harvest losses is that they can also take a holistic view of your financial picture to determine the most efficient way to manage tax liability.

Whether a financial advisor offers tax-loss harvesting and how they approach it may be spelled out in their client brochure. It’s not uncommon for financial advisors that offer tax-loss harvesting to use proprietary strategies to harvest losses, based on clients’ assets, goals and objectives.

A robo-advisor

Robo-advisors can also offer tax-loss harvesting and, typically, this is done automatically. Similar to how robo-advisors use an algorithm to determine your ideal asset allocation and investment strategy, they can also apply an algorithm model to harvest losses.

For example, Betterment offers tax-loss harvesting through an automated algorithm that regularly checks your portfolio for harvesting opportunities. Wealthfront’s tax-loss harvesting offering is available with all investment accounts, and you can get individual stock-level harvesting once your account balance or total net deposits reach $100,000. On the other hand, tax-loss harvesting with Vanguard Personal Advisor Services isn’t automatic and instead is done on a client-by-client basis.

Be sure to consider how well automated tax-loss harvesting with a robo-advisor works for your overall investment strategy. Before agreeing to automatically implement this strategy, consider how it may affect your tax liability for other taxable investment accounts you own elsewhere.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.