The Ultimate Guide to Tax-Loss Harvesting

Tax-loss harvesting is a powerful strategy that investors can use to reduce their taxable income. This type of strategy typically involves selling underperforming investments at a loss to offset capital gains (or ordinary income) to optimize portfolio returns. 

As effective as tax-loss harvesting can be, there are a number of important details that investors need to be aware of in order to implement the strategy successfully while following regulations. In this comprehensive guide, we’ll examine tax-loss harvesting in depth, looking at its benefits, drawbacks, mechanics, and suitability for different types of investors.

Table of Contents

1. What is tax-loss harvesting?
2. How does tax-loss harvesting work?
3. What is the wash-sale rule?
4. What are the benefits of tax-loss harvesting?
5. What are the drawbacks of tax-loss harvesting?
6. When should you avoid tax-loss harvesting?
7. Is tax-loss harvesting right for you?
8. FAQs

What is tax-loss harvesting?

Tax-loss harvesting is a strategy that minimizes the taxes owed on capital gains by selling underperforming investments at a loss. Investors can reduce their overall tax liability by strategically realizing losses to offset both short-term and long-term capital gains when using this strategy.

What’s more, if the losses exceed the gains, they can be used to reduce ordinary taxable income up to a limit of $3,000 per year ($1,500 if married and filing separately). Unused losses can also be carried forward to offset gains in future years, allowing for long-term tax optimization.

Tax-loss harvesting is especially useful during volatile market conditions, as price fluctuations can create opportunities to realize losses without significantly disrupting an investor’s overall portfolio strategy. This strategy gives individuals the opportunity to reinvest in comparable but not “substantially identical” assets (as defined by the IRS), and maintain a similar portfolio exposure. 

This reinvestment step is important as it differentiates tax-loss harvesting from simply attempting to predict the market or accepting losses.

How does tax-loss harvesting work?

Tax-loss harvesting involves a series of steps that allow investors to reduce their tax obligations while keeping their investment goals on track:

1. Identify gains and losses

The first step is to review your portfolio to identify both realized gains and unrealized losses. The aim is to find investments that have declined in value since purchase, making them suitable for sale.

1. Sell at a loss

Once underperforming investments are identified, investors should sell them to realize a capital loss. The tax treatment of this loss will depend on how long the asset has been held. Short-term losses (from assets held for one year or less) offset short-term gains, while long-term losses (from assets held for more than one year) offset long-term gains.

1. Offset gains and income

The realized losses are then used to offset the corresponding capital gains. 

For example, let’s assume an investor made a capital gain on an asset amounting to $30,000. The investor simultaneously makes a loss on another asset of £35,000. Tax-loss harvesting allows the investor to offset the loss against the gain, resulting in a $5,000 loss. 

Of that $5,000 loss, $3,000 can be written off annually ($1,500 if married and filing separately), with the remaining $2,000 used to offset future gains.   

Assuming the investor is a 35% marginal tax rate payer, that equates to tax savings of $30,000 x 15% long-term capital gains tax ($4,500), plus $3,000 x 35% ordinary income tax ($1,050). All of this adds up to a total tax saving of $5,550. 

1. Reinvest the proceeds

After selling losing investments, it’s important to reinvest in similar (but not substantially identical) assets. For example, an investor might sell an underperforming tech stock and reinvest in a tech-focused exchange-traded fund (ETF). This allows the investor to maintain market exposure without violating IRS regulations. Of these regulations, investors need to pay particular attention to the wash-sale rule.

What is the wash-sale rule?

The wash-sale rule is an IRS regulation that prohibits investors from claiming a tax loss on a security if they repurchase the same or a “substantially identical” security within a 60-day window (either 30 days before or after the sale).   

The most straightforward way to avoid a wash sale is to wait at least 31 days before repurchasing the same security. Another option is to consider investing in a similar, but not substantially identical, asset. However, determining what constitutes a “substantially identical” asset can be complex and may require professional advice.

The IRS doesn’t provide a precise definition for “substantially identical” securities. Instead, it advises taxpayers to consider all relevant factors and circumstances surrounding the transaction. As a general rule, though, stocks of two distinct companies are not considered substantially identical, except in specific instances such as corporate reorganizations. 

To make sure you stay compliant and achieve the tax-loss harvesting benefits you hope for, it’s advisable to gain the insight of an experienced professional. A tax advisor from Harness can help guide you through the tax-loss harvesting process, tailoring the strategy to your specific circumstances and goals. 

 

What are the benefits of tax-loss harvesting?

Tax-loss harvesting offers several advantages for investors seeking to improve after-tax returns, providing both immediate and long-term benefits:

Tax savings: The prime benefit of tax-loss harvesting is the ability to offset capital losses against capital gains, which can significantly reduce or even eliminate capital gains taxes. Unused losses that exceed annual limits can also be carried forward to future tax years.

Portfolio rebalancing: Selling underperforming assets helps investors maintain an optimal asset allocation.

Improved after-tax returns: Reinvesting the tax savings from tax harvesting losses allows investors to benefit from compound growth, leading to more efficient wealth-building over time.

Market volatility opportunities: Tax-loss harvesting is particularly beneficial during market downturns. Falling prices provide opportunities to harvest losses and reinvest in similar assets at lower costs, positioning investors for higher potential gains when markets recover.

What are the drawbacks of tax-loss harvesting?

Beyond remaining compliant with the IRS’s wash-sale rule, there are a number of other potential drawbacks that investors should consider before implementing a tax-loss harvesting strategy. 

Transaction costs: Frequent trading to harvest losses can result in higher costs, including brokerage fees and commissions, and an increased risk of tracking errors. These issues can erode the benefits of tax-loss harvesting, particularly for smaller portfolios.

Short-term tax benefits: Some argue that consistent tax-loss harvesting—even with the intention of repurchasing the asset after the wash-sale period—can ultimately reduce your overall cost basis. Unfortunately, it could also lead to larger capital gains and taxes in the future. 

While there may be some truth to that, it assumes consistent investment growth and accurate predictions of future capital gains tax rates. In short, the present value of current tax savings is seen as more valuable than uncertain future tax liabilities. 

Complexity: Effective tax-loss harvesting requires careful tracking of realized and unrealized gains and losses, as well as adherence to IRS rules. Without professional assistance or automated tools, this can be complicated and time-consuming for investors.

Potential for suboptimal timing: Selling investments at a loss during market downturns could lead to missed opportunities for recovery once the market rebounds. This is particularly relevant for highly volatile assets such as futures that can swing between losses and profits in the space of an afternoon. 

State-level variations: State tax laws can significantly impact the effectiveness of tax-loss harvesting strategies. PA and NJ, for instance, don’t allow carryovers. As a result, it’s crucial to consult with a qualified tax advisor who understands your state’s tax laws. 

When should you avoid tax-loss harvesting?

Although tax-loss harvesting can be a valuable tactic, it’s not suitable for every situation. There are certain scenarios where it may be best to avoid the strategy.

When you have no capital gains to offset: If you don’t have realized capital gains or are in a lower tax bracket, the tax benefits of harvesting losses may be minimal. Without gains to offset, the strategy provides little value.

When your investment strategy is based on diversification: tax-loss harvesting is better suited to investors with shorter-term investment goals. Selling assets purely for tax purposes can disrupt long-term investment strategies and reduce diversification.

When you have limited expertise: tax-loss harvesting requires careful monitoring and compliance with IRS regulations. Without professional guidance, any mistakes made could easily negate the benefits of the strategy. 

Is tax-loss harvesting right for you?

For high tax bracket investors, especially those with significant capital gains or high ordinary income taxes, tax-loss harvesting can offer major benefits by reducing your overall tax burden. It should be noted, however, that tax-loss harvesting is only applicable to taxable accounts and doesn’t apply to tax-advantaged accounts like IRAs or 401(k)s. 

As a strategy, tax-loss harvesting is most effective for disciplined portfolio managers who carefully monitor portfolio performance and strategically reinvest in similar but not identical assets. With dynamic markets providing frequent opportunities to harvest losses, investors in volatile assets can benefit greatly.     

Determining whether tax-loss harvesting is right for you ultimately depends on several factors, including your financial situation and investment goals. Moreover, the complexity of tax-loss harvesting requires professional guidance in most cases, with the rules and dynamics of tax-loss harvesting often being challenging to manage in practice. 

For cases like these, a platform like Harness can help. Harness specializes in connecting individuals with innovative advisory firms that offer personalized tax strategies tailored to specific circumstances and goals. With a tax advisor from Harness, you can pursue a tax-loss harvesting strategy that’s executed in the most beneficial way for you.

 

FAQs

Get answers to the most commonly asked questions about tax loss harvesting

What is the tax-loss harvesting limit?  

The IRS allows investors to offset up to $3,000 ($1,500 if married filing separately) of ordinary income annually using tax-loss harvesting. Additional losses can be carried forward to future years to offset capital gains or taxable income, providing long-term tax benefits.  

What are the tax harvesting rules?  

The IRS wash-sale rule prohibits claiming a tax loss on a security if the same or a “substantially identical” security is repurchased within 30 days before or after the sale.  

Is tax-loss harvesting worth it for small portfolios?  

For smaller portfolios, transaction costs like brokerage fees may outweigh the benefits of tax-loss harvesting. Careful consideration of these costs, alongside potential tax savings, is essential before pursuing the strategy.  

Does tax-loss harvesting apply to retirement accounts?  

Tax-loss harvesting isn’t applicable to tax-advantaged accounts like IRAs or 401(k)s, as these accounts already offer tax benefits. It is only relevant for taxable investment accounts where capital gains taxes are incurred.  

How often should tax-loss harvesting be done?  

It can be done throughout the year, but many investors review their portfolios near year-end to maximize tax benefits. Regular reviews throughout the year, however, help identify opportunities, certainly in asset types or markets that are more volatile. 

Can tax-loss harvesting reduce ordinary income taxes?  

Yes, up to $3,000 ($1,500 if married filing separately) of losses from tax-loss harvesting can offset ordinary income annually. Any additional losses can be carried forward to future years, offering ongoing tax-saving opportunities. State tax laws may apply, however, that restrict carryovers. 

Is tax-loss harvesting only for stocks?  

Tax-loss harvesting applies to any taxable investment, including mutual funds, ETFs, and bonds. It’s a versatile strategy that can be tailored to various asset types to optimize tax savings across your portfolio.  

What are the risks of tax-loss harvesting?  

The risks of tax loss harvesting include violating the wash-sale rule, reduced portfolio diversification, and higher transaction fees. Improper implementation may negate tax benefits or result in penalties.

 

Tax related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.