How Valuable is Tax-Loss Harvesting?

The phrase tax-loss harvesting contains the word loss. The moment you hear it, it is natural to feel a sense of sadness, fear, or panic. After all, nobody wants to see losses in their investment portfolio.

However, your portfolio's performance is not always within your control, and there may be times when you see red instead of green. The tax-loss harvesting strategy allows you to turn those losses into an advantage. Some see the glass half full and others the glass half empty. If you are in the former group, tax-loss harvesting may help you. 

How? Let's find out and evaluate whether it is a good investment strategy.

What is the tax-loss harvesting strategy?

Tax-loss harvesting involves selling an investment at a loss to offset capital gains taxes. Here’s how it works:

You may have some investments that have increased in value, which is great and exactly what you want. However, selling these investments is likely to trigger capital gains tax. This can reduce your overall profit. This certainly isn't great, and it's not something you would want. Long-term capital gains, earned on investments held for more than one year, are taxed at rates ranging from 0% to 20%, depending on your taxable income. Short-term capital gains, earned on investments held for one year or less, are taxed at your ordinary federal income tax rate, which currently ranges from 10% to 37%.

If you have both capital gains and investment losses in the same tax year, you can use tax-loss harvesting. You can sell assets that have lost value since you purchased them to realize a capital loss. This capital loss can be used to offset the tax liability on your capital gains and reduce the amount of tax you owe. 

For example, suppose you sell an investment in your portfolio for a $15,000 capital gain. You would have to pay tax on this gain, depending on whether it is a short-term or long-term capital gain. However, if you also sell another investment at a loss of $5,000, you can use that loss to offset part of your taxable gain. As a result, you would only pay tax on a net capital gain of $10,000 instead of $15,000.

Tax-loss harvesting can be used with a range of investments, including stocks, bonds, mutual funds, cryptocurrencies, and Exchange-Traded Funds (ETFs). If your capital losses are more than your capital gains, you may also be able to use a portion of the losses to offset ordinary income tax each year. Moreover, if you have remaining losses in a particular year, you can carry them forward to future tax years. 

To use the tax-loss harvesting strategy, you need to follow a few rules. 

1. Wash sale rule

The most important one is the wash sale rule. The wash-sale rule is in place to ensure that you do not claim a tax loss and then buy the same or a substantially similar investment within roughly 30 days before or after selling it at a loss. In other words, a wash sale occurs within a 61-day window. If a transaction is considered a wash sale, you cannot use that loss to offset your capital gains.

Additionally, if you and your spouse both invest, you need to know about the wash sale rule. When it comes to spouses, your investments are evaluated together. So, if one spouse sells an investment at a loss and the other spouse buys the same or a substantially identical investment within the 61-day period, this would be seen as a wash sale. 

There are, however, some exceptions. For example, you may be able to invest in a new mutual fund or ETF that tracks a similar index as the mutual fund or ETF you sold for tax loss harvesting, provided the two investments are not considered substantially identical. You also cannot avoid the rule by selling an investment in a taxable account and buying it back in a tax-advantaged account. 

2. $3,000 rule

The second rule you need to keep in mind is that when your capital losses are higher than your capital gains, you can use up to the following limits to offset your ordinary taxable income: 

• $3,000 in net capital losses as an individual
• $1,500 in net capital losses if you are married filing separately

If your net capital losses exceed this limit, the remaining losses are not lost. Instead, you can carry them forward to future years to offset future capital gains or reduce your ordinary income by up to $3,000 per year until the entire loss has been used. This can be done indefinitely. 

For example, if you have $7,000 in net capital losses in a year and no capital gains, you can use $3,000 to reduce your taxable income for that year. The remaining $4,000 can be carried forward to future tax years, where it can continue to offset capital gains or up to $3,000 of ordinary income each year. 

3. Using the right type of loss to offset the right type of tax

When using tax-loss harvesting, you can use long-term capital losses to offset long-term capital gains, while short-term capital losses are used to offset short-term capital gains.

Is tax-loss harvesting worth it?

Tax-loss harvesting is a widely used capital gains tax strategy that can help you save money. Let’s evaluate a few points to check if it is worth it or not:

1. Potential for tax savings and tax-efficient investing

Tax-loss harvesting is a tax-saving strategy that helps reduce your overall tax liability. While market volatility is usually seen as a disadvantage, this strategy allows you to use it to your benefit. When you strategically realize investment losses, you can offset capital gains and, in some cases, reduce your ordinary taxable income as well. 

Used consistently and correctly, tax-loss harvesting can help you save taxes in multiple ways. First, it can lower the tax you owe on your capital gains. Second, if your losses exceed your gains, you may be able to use a portion of those losses to reduce your ordinary taxable income. 

Moreover, if you reinvest the tax savings instead of spending them, they can continue to grow through the power of compounding. In this way, tax-loss harvesting becomes a two-step strategy - it helps you save more on taxes today while giving you the opportunity to build more wealth over the long term. 

2. Fewer rules on the amount of savings

The tax loss harvesting strategy does come with a few rules, especially the wash-sale rule. However, apart from these requirements, the strategy is relatively simple to understand and offers a great deal of flexibility.

For starters, there is no limit on the amount of capital losses you can use to offset your capital gains. If you realize capital gains during the year, you can sell other assets at a loss to potentially lower or even eliminate your tax liability on those gains, depending on the value of your profits and losses. The strategy is also not limited to capital gains. If your capital losses are more than your capital gains, you can use up to $3,000 of the remaining losses each year to offset your ordinary taxable income, with any unused losses carried forward to future tax years.

There is a lot of flexibility with respect to the values. And this flexibility makes tax-loss harvesting suitable for portfolios of different sizes and for a wide range of investors. Whether your gains and losses are large or small, the strategy can potentially help improve your overall tax efficiency. 

3. A single year's losses can be used for years

Tax-loss harvesting is not just a one-year strategy. It can be used as a long-term tax planning tool. If your capital losses exceed the annual limit that can be used, you do not lose the remaining amount. Instead, if you have more than $3,000 in excess capital losses, you can carry them forward to future tax years to offset future capital gains or up to $3,000 of ordinary income each year, subject to the applicable tax rules.

Even if you cannot benefit from the entire loss immediately, you will be able to use it over time with the carry-forward rule. This allows you to use tax-loss harvesting for tax planning for years to come, making it a comprehensive long-term strategy rather than a one-time tax-saving approach. 

There are some things to keep in mind as well:

1. You may not have any losses to harvest

Tax-loss harvesting can be a good and effective tax-saving strategy, but it is not suitable for every situation. It only works if you have investments that have declined in value and can be sold to realize a capital loss. If your investments have performed well, which is ultimately the goal, you may not have any losses available to harvest. In such cases, you will not be able to use this strategy and will have to pay tax on your capital gains as applicable.  

2. You may incur increased transaction fees

Buying and selling investments has tax implications. It can also result in transaction costs. If you frequently sell investments to realize losses, you may incur brokerage fees, trading charges, and more. While these costs may seem small individually, they can add up over time and reduce the overall tax savings from the strategy.

Before implementing tax-loss harvesting, you must consider whether the tax benefit outweighs the transaction costs that you will pay. Speaking to a financial advisor can help you understand this in detail.  

3. It requires knowledge and understanding

Tax-loss harvesting requires sound judgment and a good understanding of investing and tax rules. Selling investments at a loss is not always the right decision. If you focus only on reducing taxes, you may overlook your long-term investment goals. Remember, a loss is only realized when you sell the investment. In some cases, it may be better to hold on to an investment and benefit from a potential recovery instead of selling it too early.

You also need to comply with rules such as the wash-sale rule, as repeated violations may attract regulatory scrutiny. Also, if you choose to implement tax-loss harvesting, ensure that your tax-saving decisions do not undermine your overall investment strategy and long-term financial goals. 

Implementing the tax-loss harvesting strategy

Before implementing the tax-loss harvesting strategy, educate yourself about the rules. While this strategy can be an effective way to reduce your tax liability, it must be used in compliance with the applicable regulations. You should also evaluate your overall financial situation, tax position, and investment objectives to determine whether tax-loss harvesting is suitable for you. There is no denying that it is a useful capital gains tax strategy. In fact, it can help offset both capital gains and, in certain cases, ordinary income.

However, do not let tax savings cloud your judgment. Avoid selling investments solely to reduce your tax bill, especially if it does not align with your long-term goals. It is always advisable to consult a financial advisor before implementing the strategy. If you are looking for one, our financial advisor directory can help you find a suitable financial advisor near you.  

Frequently Asked Questions (FAQs) about tax-loss harvesting

1. How can I ensure I do not make a wash sale?

To avoid making a wash sale, make sure you understand the wash-sale rule in detail. Keep track of the 61-day wash-sale window by marking the dates on your calendar so you do not accidentally buy back the same or a substantially identical investment within the restricted period. You can also consult a financial advisor for guidance.

2. What are some tips to follow when using tax-loss harvesting?

Here are some best practices to keep in mind when using the tax-loss harvesting strategy:

• Work with a financial advisor to implement the strategy correctly.
• Understand the tax rules, especially the wash-sale rule, before selling investments.
• Keep your long-term financial and investment goals in mind rather than focusing only on tax savings.
• Consider waiting until later in the tax year to realize losses, as this gives you a clearer picture of your capital gains, losses, and overall tax liability for the year.  

3. Who can use the tax loss harvesting strategy?

Tax-loss harvesting can be used by investors who have realized capital gains and want to reduce the tax liability on those gains. To use the strategy, you must also have investments that have declined in value and can be sold to realize a capital loss.